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ONE BROKER GONE BAD:

PUNISHING THE CRIMINAL,

MAKING VICTIMS WHOLE

HEARING

BEFORE THE

SUBCOMMITTEE ON

OVERSIGHT AND INVESTIGATIONS

OF THE

COMMITTEE ON FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED SEVENTH CONGRESS

SECOND SESSION

MAY 23, 2002

Printed for the use of the Committee on Financial Services

Serial No. 107–71

(

(II)

HOUSE COMMITTEE ON FINANCIAL SERVICES

MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa

MARGE ROUKEMA, New Jersey, Vice Chair

DOUG BEREUTER, Nebraska

RICHARD H. BAKER, Louisiana

SPENCER BACHUS, Alabama

MICHAEL N. CASTLE, Delaware

PETER T. KING, New York

EDWARD R. ROYCE, California

FRANK D. LUCAS, Oklahoma

ROBERT W. NEY, Texas

BOB BARR, Georgia

SUE W. KELLY, New York

RON PAUL, Texas

PAUL E. GILLMOR, Ohio

CHRISTOPHER COX, California

DAVE WELDON, Florida

JIM RYUN, Kansas

BOB RILEY, Alabama

STEVEN C. LATOURETTE, Ohio

DONALD A. MANZULLO, Illinois

WALTER B. JONES, North Carolina

DOUG OSE, California

JUDY BIGGERT, Illinois

MARK GREEN, Wisconsin

PATRICK J. TOOMEY, Pennsylvania

CHRISTOPHER SHAYS, Connecticut

JOHN B. SHADEGG, Arizona

VITO FOSSELLA, New York

GARY G. MILLER, California

ERIC CANTOR, Virginia

FELIX J. GRUCCI, JR., New York

MELISSA A. HART, Pennsylvania

SHELLEY MOORE CAPITO, West Virginia

MIKE FERGUSON, New Jersey

MIKE ROGERS, Michigan

PATRICK J. TIBERI, Ohio

JOHN J. LAFALCE, New York

BARNEY FRANK, Massachusetts

PAUL E. KANJORSKI, Pennsylvania

MAXINE WATERS, California

CAROLYN B. MALONEY, New York

LUIS V. GUTIERREZ, Illinois

NYDIA M. VELA ́ ZQUEZ, New York

MELVIN L. WATT, North Carolina

GARY L. ACKERMAN, New York

KEN BENTSEN, Texas

JAMES H. MALONEY, Connecticut

DARLENE HOOLEY, Oregon

JULIA CARSON, Indiana

BRAD SHERMAN, California

MAX SANDLIN, Texas

GREGORY W. MEEKS, New York

BARBARA LEE, California

FRANK MASCARA, Pennsylvania

JAY INSLEE, Washington

JANICE D. SCHAKOWSKY, Illinois

DENNIS MOORE, Kansas

CHARLES A. GONZALEZ, Texas

STEPHANIE TUBBS JONES, Ohio

MICHAEL E. CAPUANO, Massachusetts

HAROLD E. FORD JR., Tennessee

RUBE ́ N HINOJOSA, Texas

KEN LUCAS, Kentucky

RONNIE SHOWS, Mississippi

JOSEPH CROWLEY, New York

WILLIAM LACY CLAY, Missouri

STEVE ISRAEL, New York

MIKE ROSS, Arizona

BERNARD SANDERS, Vermont

Terry Haines, Chief Counsel and Staff Director

SUBCOMMITTEE ON OVERSIGHT AND INVESTIGATIONS

SUE W. KELLY, New York, Chair

RON PAUL, Ohio, Vice Chairman

PETER T. KING, New York

ROBERT W. NEY, Texas

CHRISTOPHER COX, California

DAVE WELDON, Florida

WALTER B. JONES, North Carolina

JOHN B. SHADEGG, Arizona

VITO FOSSELLA, New York

ERIC CANTOR, Virginia

PATRICK J. TIBERI, Ohio

LUIS V. GUTIERREZ, Illinois

KEN BENTSEN, Texas

JAY INSLEE, Washington

JANICE D. SCHAKOWSKY, Illinois

DENNIS MOORE, Kansas

MICHAEL CAPUANO, Massachusetts

RONNIE SHOWS, Mississippi

JOSEPH CROWLEY, New York

WILLIAM LACY CLAY, Missouri

(III)

C O N T E N T S

Page

Hearing held on:

May 23, 2002 ..................................................................................................... 1

Appendix:

May 23, 2002 ..................................................................................................... 63

WITNESSES

THURSDAY, MAY 23, 2002

Doherty, David, Executive Vice President for Enforcement, New York Stock

Exchange ............................................................................................................... 12

Fazio, Carl, Defrauded Investor, Aurora, Ohio ..................................................... 8

Hommel, Thomas, Managing Director and Co-Head of Global Litigation, Lehman Brothers ........................................................................................................ 37

Kaplan, Mark E., Managing Director and General Counsel, SG Cowen Securities ......................................................................................................................... 35

Lackritz, Marc E., President, Securities Industry Association ............................ 43

Richards, Lori, Director, Office of Compliance, Inspections, and Examinations,

Securities and Exchange Commission ................................................................ 11

Sibears, Daniel M., Senior Vice President and Deputy for Member Regulation,

National Association of Securities Dealers ........................................................ 39

Skolnik, Bradley W., Indiana Securities Commissioner and Chairman, Enforcement Section, North American Securities Administrators Association ... 41

Stout, Golda Lewis, Defrauded Investor, Elgin, Illinois ....................................... 10

APPENDIX

Prepared statements:

Kelly, Hon. Sue W. ........................................................................................... 64

Oxley, Hon. Michael G. .................................................................................... 65

Jones, Hon. Stephanie Tubbs .......................................................................... 67

LaTourette, Hon. Steve C. ............................................................................... 68

Doherty, David .................................................................................................. 79

Fazio, Carl ......................................................................................................... 126

Hommel, Thomas .............................................................................................. 104

Kaplan, Mark E., .............................................................................................. 96

Lackritz, Marc E., ............................................................................................. 122

Richards, Lori ................................................................................................... 69

Sibears, Daniel M., ........................................................................................... 109

Skolnik, Bradley W., ........................................................................................ 116

Stout, Golda Lewis ........................................................................................... 129

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Kelly, Hon. Sue W.:

Frank Gruttadauria letter to the Securities and Exchange Commission

and the Federal Bureau of Investigation .................................................... 166

Jones, Hon. Stephanie Tubbs:

Arbitration Agreements between Richard Lopardo v. Frank Gruttadauria 167

Duvin, Cahn & Hutton letter regarding Mr. Samuel Glazer, May 21,

2002 ................................................................................................................ 154

Gruttadauria Lawsuits Threaten Lehman Profits, Cleveland Plain Dealer,

April 17, 2002 ................................................................................................ 152

NYSE Investigating Gruttadauria ex-aide, Cleveland Plain Dealer, April

27, 2002 .......................................................................................................... 150

Page

IV

Jones, Hon. Stephanie Tubbs—Continued

New York Stock Exchange Hearing Panel Decision, July 10, 1998 ............. 135

LaTourette, Hon. Steve C.:

Account of Carl Fazio ....................................................................................... 157

Account of Dominic A. Visconsi, Sr., ............................................................... 158

Hommel, Thomas:

Written response to questions from Hon. Stephanie Tubbs Jones ............... 186

Kaplan, Mark E.:

Written response to questions from Hon. Stephanie Tubbs Jones ............... 190

Richards, Lori:

SEC’s Examination Report on Frank Guttadauria, November 1993 ........... 133

Sarantakis, Georgia C., Defrauded Investor, prepared statement ...................... 159

Yale, Judy Meyerhoff, Defrauded Investor, prepared statement ......................... 163

(1)

ONE BROKER GONE BAD:

PUNISHING THE CRIMINAL,

MAKING VICTIMS WHOLE

Thursday, May 23, 2002

U.S. HOUSE OF REPRESENTATIVES

SUBCOMMITTEE ON OVERSIGHT AND INVESTIGATIONS

COMMITTEE ON FINANCIAL SERVICES

Washington, D.C.

The subcommittee met, pursuant to call, at 9:30 a.m., in Room

2128 House Office Building, Hon. Sue W. Kelly [chairwoman of the

subcommittee] presiding.

Present: Representatives Kelly, Ney, Cantor, Tiberi, Inslee, Jones

of Ohio, Clay, and Oxley (ex officio).

Also Present: Representatives Hastert and LaTourette.

Chairman KELLY. Good morning, ladies and gentlemen. This

hearing of the Oversight and Investigations Subcommittee of the

House Committee on Financial Services will come to order.

I want to thank all members of Congress who are present today.

Without objection, all members present will participate fully in the

hearing, and their opening statements and their questions will be

made part of the official hearing record.

On January 11, 2002, Frank Gruttadauria, a Cleveland branch

manager and broker, mailed a letter to the FBI admitting to 15

years of wilful fraud and theft of his clients’ savings, and he disappeared. In the aftermath of this revelation, law enforcement, the

regulators, the successive owners of that branch, and

Gruttadauria’s clients, began to uncover the extent of this one broker’s deceitfulness and the intricate web of lies that he employed

to perpetrate his fraud.

We do know that Mr. Gruttadauria is accused of at least—stealing at least $40 million of his client’s savings, while sending his clients fake statements stating that their savings had grown to an estimated combined total of $260 million. Today, Mr. Gruttadauria is

in federal custody after less than a month of being on the run.

It appears that his efforts to evade detection by the firms and

regulators were much better than his ability to evade the law. One

issue is clear: Mr. Gruttadauria and any who assisted him will be

punished for their crimes. From my initial review of this case, Mr.

Gruttadauria had the ability to perpetrate this fraud because of his

position in the Cleveland branch as both manager and a broker.

This put him in the position of supervising himself, which is a key

point in this case.

2

Another key point is the lack of complaints in regard to Mr.

Gruttadauria’s actions. The majority of investigations against problem brokers appear to be triggered by five or more complaints.

Since Mr. Gruttadauria was able to send false statements to his clients and forged any authorization he needed, he appears to have

avoided scrutiny, including anything that occurred through traditional warning signs.

The purpose of this hearing is to examine this case in an effort

to determine what steps are warranted to ensure that similar fraud

and theft is prevented. Our responsibility is to ensure that scams

such as this will not go undetected again. In order to do this, we

must take a step back from the particulars of this case and examine the systems that firms and regulators have in place to detect

such fraud by managers’ brokers.

We know that the securities industry is very full of intelligent

people. If they put their mind to it, they could potentially inflict a

great deal of harm on the savings of many families and investors.

To preserve and bolster investor confidence, we must gain an understanding of how the current systems were defeated so consistently over the course of approximately 15 years by Mr.

Gruttadauria.

I want to thank all of our distinguished witnesses for taking the

time out of their busy schedules to join us here today. The committee understands the constraints that some of our witnesses are

under and their inability to discuss some of the specifics of the case

due to the ongoing nature of the Gruttadauria investigation. The

last thing we want to do is to inadvertently harm the prosecution

of Mr. Gruttadauria or any of his accomplices.

We appreciate your willingness to come here today to discuss the

issues to the best of your ability. I also want to make it clear to

the members of this committee, and to our witnesses, it is my intention to enforce the five-minute rule, which limits statements

and questions to a five-minute period. This will ensure that everyone has an equal chance to state their views, and I thank you all

in advance for this effort.

I want to now recognize the Speaker of the U.S. House of Representatives, our Speaker, Mr. Dennis Hastert, for an introduction.

Mr. Hastert, we welcome you here today. Your presence lends a

great deal to this hearing. Thank you. Mr. Speaker, your mike

needs to be turned on.

[The prepared statement of Hon. Sue Kelly can be found on page

64 in the appendix.]

The. SPEAKER. I haven’t done this for a while. No.

[Laughter.]

Chairman Kelly, thank you very much for holding this hearing

today. I also want to thank Mr. LaTourette, because he worked to

bring this about, and also the Chairman of the full committee for

making this happen.

You know, one of our bases of wealth in this country is the people having confidence in securities and 401Ks and money markets

and mutual funds that they can invest their money, the money that

they worked hard or inherited or saved or scrimped, or however

they accumulated it, and to see that money grow, so that they can

have something to live their life with and to pass on to their chilVerDate 11-MAY-2000 11:40 Oct 29, 2002 Jkt 000000 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 C:\DOCS\82396.TXT HBANK1 PsN: HBANK1
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dren and their grandchildren. And we have seen that wealth grow

in this country over the last few years.

But I have a constituent here today, Mrs. Golda Stout, from Elgin, Illinois, who invested over $600,000, or her life savings, everything she had, with a broker, the same broker that you had

mentioned in your opening statement. She lost that money, not because of fault of her own, in good faith, under the confidence that

she was investing with a brokerage house that had a good name,

a good reputation, and all of a sudden that fortune, that savings,

that lifetime investment that she had, was gone.

We need to make sure that, first of all, those people who perpetrated those deeds are punished. But that certainly doesn’t make

whole those people who were the investors. We also need in this

Congress, the body that makes the laws for this country, to make

sure that we have a system in place that people have confidence

that they can invest in the markets, invest in the security systems

that we have today, that they have confidence that if a brokerage

house is there and has a good name, it is something that they can

have confidence in, and that there is a system, that we have checks

and balances, that this type of thing doesn’t happen again.

So, Madam Chairman, thank you for having this hearing today.

Again, I want to thank Mr. LaTourette for bringing this forward,

and for the Chairman of the full committee for allowing this hearing. But most important, I also want to thank those people who are

here today to bring this issue forward, to lay out what the problem

is, and try to help us to start to find the solutions to this problem.

I also, again, want to thank my constituent, Mrs. Golda Stout,

for being here today and testifying.

So thank you very much, Madam Chairman.

Chairman KELLY. Thank you very much, Mr. Speaker.

We go now to the Chairman of the full committee, Mr. Oxley, for

an opening statement.

Mr. Oxley.

Mr. OXLEY. Thank you, Madam Chairwoman.

And, Mr. Speaker, thank you for your appearance before the

committee today. We welcome you back anytime.

I want to take this opportunity to thank you, Mrs. Kelly, for this

important hearing. The subject of today’s hearing, Mr.

Gruttadauria, who had as many as 470 clients during the height

of his success, earning more than $6 million in commissions in a

good year, for some unknown reason that was apparently not

enough. It appears that over 15 years he sent false statements to

two dozen or more of his clients.

It is further alleged that over the same 15-year period he misappropriated possibly hundreds of millions of dollars, somewhere

between $125- and $700 million from those clients, several of whom

treated him as warmly as they would members of their own families. One client even made him the executor of his estate.

He was never caught. Apparently, feeling that he was on the

verge of being found out, he called his activities to the attention of

the FBI, fleeing to Colorado where he eventually surrendered to

authorities. State and federal authorities, as well as the brokerage

firms which employed him, are continuing their months-long effort

to uncover the extent of his activities. We can only hope that those

4

efforts will bring a sense of closure to his many victims and their

families.

It is my sincere hope that our efforts today will be of help in this

ongoing investigation. We will have the opportunity to hear directly

from several of Mr. Gruttadauria’s victims, and we will learn first

hand from them how he concocted a scheme whereby he misdirected their brokerage account statements to post office boxes

which he rented and personally controlled. He then created false

statements in order to mislead his clients about the real value of

their investments.

Although some may feel that outages of the sort that were inflicted by Mr. Gruttadauria upon his trusting clients are systemic,

the efforts being undertaken by the law enforcement prosecutors,

SEC, and New York Stock Exchange, Lehman Brothers, and S.G.

Cowen Securities would certainly indicate that this is certainly not

the case. Hindsight is always perfect, yet our examination revealed

that there were missed opportunities for the various authorities to

stop his criminal activity.

The presence of representatives today from the SEC, New York

Stock Exchange, the SIA, National Association of Securities Dealers, and North American Securities Administrators, underscores

their commitment to ensure that violations of securities law such

as this particularly egregious case do not occur in the future, and

I look forward to hearing from them today about their efforts.

Let me also note that this committee was pleased to work with

the SEC in order to provide it with a significant increase in its

budget to allow for a much needed escalation of its enforcement capabilities. As a matter of fact, we provided in the reauthorization

bill that passed this committee unanimously a 50 percent increase

in the budget in the Enforcement Division of the SEC.

Apparently, the SEC also had some information years ago on Mr.

Gruttadauria, and I also look forward to hearing from the SEC

about how it will improve its processes.

Before I close, Madam Chairwoman, I want to particularly pay

tribute to our good friend, Steve LaTourette, for his doggedness

and his determination on this case. Steve was a renowned prosecutor before he came to Congress, and he has taken those skills

with him on this committee. We are pleased to have him on the

committee as a very aggressive and active member, and this hearing, in many ways, is a tribute to his steadfastness on this issue.

And I am pleased to yield back the balance of my time.

[The prepared statement of Hon. Michael G. Oxley can be found

on page 65 in the appendix.]

Chairman KELLY. Thank you very much, Mr. Chairman.

We now go to Ms. Tubbs Jones.

Mrs. JONES OF OHIO. Thank you, Madam Chairwoman.

To our Chairman of the committee and my colleagues, I find myself this morning in a sad situation. I look out in the audience, and

I see people from the 11th Congressional District, who I have

known for many, many years, in a position where their life savings

have been denigrated as a result of the conduct of Frank

Gruttadauria.

When I look out in the audience, I see former Council President

Jim Stanton from the great city of Cleveland; Mary Boyle, a CounVerDate 11-MAY-2000 11:40 Oct 29, 2002 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 C:\DOCS\82396.TXT HBANK1 PsN: HBANK1
5

ty Commissioner from Cuyahoga County; Mr. Carl Fazio—and we

have a great relationship because his grandson Anthony and my

son Mervin attended school together.

It is, in my opinion, a shame that we would be here this morning

where we have someone who has literally deprived hardworking

people, who have worked all of their lives, of their life savings, of

that blanket to cover them in a time of most need.

As we come today before this subcommittee, there are several

questions that we will all want to have answered, but particularly

of interest to me will be what, in fact, the SEC, in 1993, knew

about Frank Gruttadauria and did not do enough to keep him from

being engaged in a conduct subsequently.

I do want to have admitted to the record at some point, Madam

Chairwoman, a finding by the New York Stock Exchange from 1998

of conduct of Frank Gruttadauria and S.G. Cowen’s failure to supervise producing branch manage officers acting in the capacity of

registered representatives. In this instance, we have Frank

Gruttadauria acting as a branch manager/officer, who—and the

compliance officer within that company was the person who reported directly to Frank Gruttadauria. If that is not a signal that

something is going wrong, I don’t know what is.

[The following information was subsequently furnished by Hon.

Stephanie Tubbs Jones for the hearing record.]

Chairman KELLY. Without objection.

Mrs. JONES OF OHIO. Thank you.

It is our job as members of Congress to sit and listen intently,

constantly try to keep our sympathies for the victims of these

crimes from clouding our objectivity that we must maintain. However, it is a tough piece to try and keep that sympathy from clouding part of our judgment in this instance.

But be that as it may, Frank Gruttadauria, who—frankly, whose

conduct is shocking—is alleged to have stolen tens of millions of

dollars, and I won’t repeat that because everyone said that. But for

the record, everyone knows the amount of dollars and the people

involved. But how was he able to gain the trust of so many people?

How was he able, for 15 years, to engage in this conduct and go

undetected? How is it that there were prior violations by—noted by

the New York Stock Exchange and the SEC where he was able to

continue in his conduct?

And by the end of this hearing this morning, it is my hope that

we will have information sufficient to assist these victims in the

process of attempting to collect their dollars back from either

Frank Gruttadauria or his supervisors, or the investment companies that are involved.

But even more so, that we will have information and opportunity

to see that we put in place rules and regulations that will not allow

other people to be victimized as a result of such conduct, and that

we will be able to look past and maybe even foreshadow some of

the other conduct that investors are engaged in in this instance.

I yield the balance of my time, Madam Chairwoman. I want to

compliment you and my colleague from northeast Ohio, Steve

LaTourette, for giving us the opportunity to have this hearing this

morning.

Thank you very much.

6

[The prepared statement of Hon. Stephanie Tubbs Jones can be

found on page 67 in the appendix.]

Chairman KELLY. Thank you very much, Mrs. Tubbs Jones.

We turn now to Mr. Tiberi.

Mr. Tiberi, do you have an opening statement?

Mr. TIBERI. I do not have an opening statement, Madam Chairwoman.

Chairman KELLY. Thank you.

We turn to Mr. LaTourette. Mr. LaTourette, we are pleased to

have you join us this morning.

Mr. LATOURETTE. Thank you very much, Madam Chairwoman,

and I want to thank you, and also the Chairman of the full committee, Mr. Oxley, for convening this hearing today.

I also want to compliment your staff, Madam Chairwoman, for

the outstanding investigatory work that they have done in getting

us ready for this hearing. And there is a number of people we could

talk about, but Andy Cochran, who is seated to your left, has really

done an outstanding job, and he deserves our thanks for getting us

to where we are today.

Madam Chairwoman, many of us in the greater Cleveland area

were startled, shocked, and dazed when we found out that a number of our friends and neighbors had been victimized by a broker

who worked for Lehman Brothers, Frank Gruttadauria. We discovered that he had fled town, leaving a note and a computer disk for

the FBI, after bilking the firm’s clients out of money that has

ranged from $40 million, it has been complained of, to, as the

Chairman of the full committee indicates, up to $700 million.

I know we have Mr. Fazio here today, who will talk about $26

million that he and he alone lost. His victims ranged from some

very wealthy people to moderate income people, who were investing

for their retirement years.

By maintaining a desktop computer, in violation of his firm’s

rules, by setting up a phony post office box, by mailing fraudulent

statements and juggling funds, it appears that Mr. Gruttadauria

was able to craft a Ponzi scheme that lasted for 15 years, and only

collapsed, despite what I read in The Wall Street Journal today,

only collapsed because there was a cash call on a divorce case of

a rather wealthy client, and also because of the persistence of Mrs.

Golda Stout. And I think that perhaps the SEC and some of the

regulators should hire Mrs. Stout to supervise and watch things.

It is my understanding that she initially indicated she wanted to

view her investments online, was told that, ‘‘Oh, we don’t offer that

service,’’ and it is only because she kept pushing and pushing and

pushing that eventually Mr. Gruttadauria, among other reasons,

left town.

Some will come before this subcommittee today and say that this

is just one very crooked broker gone bad, we are really sorry, but

it happens, but that there are no systemic difficulties or problems

that require the attention of this committee or any other committee

in the Congress. That might be the case were there not some historical context not only for the Book of Business while it was maintained by S.G. Cowen, but also after it was purchased by Lehman

Brothers.

7

Mrs. Tubbs Jones and others have mentioned the 1993 complaint, and in that complaint the SEC discovered that Mr.

Gruttadauria was in charge of an account that had an equity of

$96,000. It had losses of $86- to $88,000, and commissions charged

of $39,000 in a six-month period. It is my understanding—and we

are looking forward to hearing from the SEC today—but they neglected to talk to the account holder and only talked to Mr.

Gruttadauria.

Someone who will not show up today as a witness is a friend of

mine from Cleveland, Dominic Visconsi, Sr. His accounts will enter

into evidence later, returned over a four-year period 54 percent, 99

percent, 19 percent, 100 percent, and 43 percent.

Also, Ms. Tubbs Jones mentioned the fine levied by the New

York Stock Exchange for failure to supervise in 1998. And at the

same time, Madam Chairwoman, Lehman Brothers was involved in

litigation by another broker by the name of Ahmed Dahouk, who

maintained a desktop computer, set up phony post office boxes,

mailed fraudulent statements, juggled funds, and apparently in

doing the due diligence when they purchased the Cowen business

this did not seem to raise any red flags.

Lastly, Madam Chair, it is my understanding that the supervising partner at Lehman Brothers, who supervised Mr.

Gruttadauria for the year that he had the business, earned a base

salary of $450,000, received bonuses of $8 million, and stock options of $29 million. And the question that I think needs to be

raised is: why should he be worried about what happened with Mr.

Gruttadauria and his clients?

Thank you. I yield back.

[The following information was subsequently furnished by Hon.

Steve C. LaTourette for the hearing record.]

Chairman KELLY. Thank you, Mr. LaTourette. And without objection, we will accept that in the record.

Also, without objection, I would like to enter into the record a

copy of the letter that Mr. Gruttadauria sent to the Cowen & Company and to Chase Manhattan and to the FBI. He sent copies of

it to a number of people, not just those two listed. And without objection, that letter will also be included in the record.

With that, if there are no further opening statements, I am going

to introduce the first panel. We sincerely appreciate the effort it

took for all of you to prepare your testimony, and the two of you

who have traveled here some distance to be here today with us.

Our panel includes Mr. Carl Fazio of Aurora, Ohio; and Mrs.

Golda Lewis Stout of Elgin, Illinois; both of whose finances were

devastated by Mr. Gruttadauria’s fraud. Lori Richards, the Director

of Office of Compliance, Inspections, and Examinations at the Securities and Exchange Commission. We welcome you, Ms. Richards.

And Mr. David Doherty, Executive Vice President for Enforcement

at the New York Stock Exchange.

I want to thank each of you for agreeing to testify before us

today, and I welcome you on behalf of the committee.

Without objection, your written statements and any attachments

will be made a part of the record. You will each now be recognized

for a five-minute summary of your testimony. There are lights in

8

front of you that will indicate how much time you have. You see

the boxes there on the table.

The green light signifies that you are in the first four minutes

of your summary. The yellow light will turn on when you have a

minute remaining. And the red light will turn on when your time

has expired.

And we will begin now with you, Mr. Fazio. Thank you for being

here.

STATEMENT OF CARL FAZIO, AURORA, OHIO

Mr. FAZIO. Thank you, Chairman Kelly, Members of the House

Financial Services and Oversight and Investigations Subcommittee.

Thank you for inviting me to be with you today. I will share with

you my family’s story of betrayal by four of America’s great institutions—Lehman Brothers, Cowen & Company, S.G. Cowen, and

Hambrecht & Quist.

Caution shown by today’s investors not only reflects the lack of

confidence the public has in corporate accounting; it demonstrates

that the public also understands that major investment banking

firms only say the right thing. They do not do it, and, more importantly, they apparently turn a blind eye when investors are hurt.

I am Carl Fazio. I came to this country at the age of three.

Through great effort and energy, my family was able to build one

fruit stand into Fisher-Fazio’s, a major chain of supermarkets

which ultimately became a New York Stock Exchange company. At

the time of its sale, I was its chairman, and we employed approximately 20,000 people.

Today, as I stand before you, although I earned and invested a

handsome amount of money, I have a few liquid assets. I am unable, at the age of 85, to pay my bills as they become due, and I

am forced to sell my home, all because of the greed of Lehman

Brothers, Cowen & Company, S.G. Cowen, and, possibly,

Hambrecht & Quist.

While focusing on generating fees, they failed to police their own

brokers and employees. We have only recently learned that the

New York Stock Exchange, in a disciplinary proceeding against

Cowen & Company dealing with 1994 and 1995, criticized it for

having compliance people subordinate to branch office managers.

Even though the Stock Exchange found this deficiency, it was

never corrected.

In Cleveland, Robert Semanek, the firm’s compliance person, reported to Frank Gruttadauria. This is wrong. Neither Cowen &

Company, S.G. Cowen, nor Lehman Brothers changed their procedures. That is a key reason why Frank Gruttadauria could generate fraudulent statements on his personal computer which he

had in his office.

He had the computer even though, according to some newspaper

reports, it was against company policy. My assets have been stolen

from me, not just by Frank Gruttadauria, but by the collective efforts of the brokerage firms that lent them their credibility and resources and turned their backs on protecting me.

After the sale of my company, at the request of my first wife,

through her close friend, I entrusted some of my funds to Frank

Gruttadauria and his firm. Over the years, he became as close to

9

me as one of my own sons. I viewed him as a member of my family

and proudly watched him receive accolades in the investment community and rise up the ladder to becoming a senior director of S.G.

Cowen and the branch office manager for Lehman Brothers.

His positions in the companies gave me confidence. Little did I

know that at some time, from the little records that I have been

able to get since Frank Gruttadauria admitted his frauds and ran

away, maybe as early as the 1990s, he took my money and misappropriated it in order to grow his commission income, all the

while sending me false statements which reflected the trades I

sought in the market.

He did this while encouraging me to deposit more and more

money. Ultimately, all of my liquid assets were put under the control of Frank Gruttadauria, who stole them.

I believe I am a very knowledgeable investor. I told Mr.

Gruttadauria what I wanted to buy and what I wanted to sell. I

made my own trades. I was in constant contact with him and his

office, and I reviewed what I believed to be confirmations and my

statements. Little did I know that I was dealing with smoke and

mirrors.

Now their greed has devastated me. And if the brokerage firm’s

actions are not bad enough, S.G. Cowen, a brokerage firm I sued,

is now attempting to manipulate the court system by removing my

claim to arbitration. As they said in their motion, and I quote,

‘‘Plaintiffs must pursue their claims in arbitration before a panel

of—an appropriate self-regulatory organization.’’

I am 85 years old. I need this money to live on now. On January

28, I met with Lehman Brothers and told them of my urgent need

for money.

And I would like to close by reading you a portion of Lehman’s

mission statement. I quote, ‘‘We are one firm, defined by our unwavering commitment to our clients.’’ In my situation, they not

only wavered, they punted, and now they just don’t care.

Thank you for your time.

[The prepared statement of Mr. Carl Fazio can be found on page

126 in the appendix.]

Chairman KELLY. Mr. Fazio, we thank you for your statement.

That is certainly a very, very moving statement.

I want to explain to the people here, and to our panel, that the

business on the floor today is such that we may be moving back

and forth to vote. We have a vote that has just been called.

So what I am going to try to do in order—because I know some

of you have planes that you need to meet, and so forth, I am going

to be trading off the Chair with people, so that we are going to

have a rotating group of people moving back and forth, so that we

can keep this hearing open and keep it going.

So with that being said, I hope you will indulge us in changing

people sitting in this char. I am still running the hearing, and I

will be back. I am going to be going back and forth to vote now and

then.

With that, I want to go to you, Mrs. Stout.

10

STATEMENT OF GOLDA LEWIS STOUT, ELGIN, ILLINOIS

Mrs. STOUT. I, too, want to thank the members of the Financial

Service Committee and the subcommittee for inviting me to testify.

Over the past months, I have watched others testify. I am impressed with their apparent confidence and calm demeanor. I assure you that this is not my state at this moment.

As my opening statement, I want to share with you an edited

version of a letter sent to my Congressman for my district, Dennis

Hastert. I met Dennis Hastert in Elgin many, many years ago

when he was campaigning for his first term of the House of Representatives. We were both much younger at that time.

I was born in 1915 on a small farm in central Iowa. I suffered,

along with millions of other American citizens, the ravages of depression. I made a commitment to work hard and save. My life has

been productive, and I am very proud of my accomplishments. I

have a family which I truly love, and they have the same feeling

for me.

As a result of my savings and investing, I felt secure in knowing

that my remaining years of life would be without financial worry,

but all that was changed in January of 2002 with the news of the

fraud perpetrated on many others and on me by the managing director of the Cleveland office of Lehman Brothers, Frank Dominic

Gruttadauria, who formerly worked for S.G. Cowen, Cowen & Company.

The complete story of Mr. Gruttadauria will not be known, if

ever, for years to come. However, by his own witness statements

to the FBI, he has defrauded his clients for over 15 years. Given

some of the most recent articles, it appears to me that the process

of recovering my lost investments may be long and expensive.

While I trusted my broker as many investment companies are

stressing in their television advertising, I was not passive with the

respect to monitoring the stockmarket and investment portfolio. I

tracked the markets daily and have records going back to 1992.

And I also verified my portfolio balance with each monthly report.

However, I did not receive the true reports. They were sent elsewhere by the brokerage firm as a result of Mr. Gruttadauria’s actions. Instead, I received a very authentic-looking account statement, which agreed with my own personal records. I also received

yearly the 1099s, which my accountant used to prepare for the individual tax returns. And over the years, Mr. Gruttadauria was

privately looting my account. All of this occurred without detection

by myself.

This brings me to the main point. Stockbrokers’ misdeeds must

be prevented from occurring again to any person who uses a brokerage account as an investment vehicle. As we all know, Social

Security should not be the foundation of any retirement plan. IRAs,

401Ks, and other investment activities are the real foundation for

retirement. In almost all cases, these activities will involve investments using a brokerage firm.

As pointed out in the article in The Wall Street Journal, the

Plain Dealer of Cleveland, active compliance monitoring and reporting is critical. My hope is that you and your colleagues in the

Congress can address, to the greatest extent possible, the need to

11

prevent stockbroker fraud and to require the brokerage firms to

monitor and enforce compliance by their officers and employees.

Thank you.

[The prepared statement of Ms. Golda Lewis Stout can be found

on page 129 in the appendix.]

Chairman KELLY. We thank you, Mrs. Stout.

We will go next to you, Ms. Richards.

STATEMENT OF LORI RICHARDS, DIRECTOR, OFFICE OF COMPLIANCE, INSPECTIONS, AND EXAMINATIONS, SECURITIES

AND EXCHANGE COMMISSON

Ms. RICHARDS. Chairwoman Kelly, Chairman Oxley, members of

the subcommittee, I appreciate the opportunity to appear before

the subcommittee today on behalf of the Securities and Exchange

Commission to discuss the Frank Gruttadauria matter and potential measures to prevent theft by registered representatives of

stockbrokers.

As I think you know, the SEC filed an enforcement action

against Mr. Gruttadauria alleging that he misappropriated customer funds for his own purposes, directing those funds to other

customers’ accounts, either as purported returns or to satisfy their

withdrawal requests. In essence, this was a Ponzi scheme, pure

and simple, taking money from some clients to cover the withdrawal requests that were made by other clients.

The SEC alleges that Mr. Gruttadauria forged client signatures

on withdrawals, made unauthorized transfers of funds, and took

customer funds purportedly to open accounts, but never actually

opened accounts. Then, to conceal the fraud from his customers, he

created and sent false account statements to customers that greatly

overstated the values of their accounts, and caused the clients’ actual account statements to be sent to post office boxes under his

own control.

I want to say, listening to the victims, Mrs. Stout and Mr. Fazio,

how much I empathize with them.

I know that the subcommittee is most interested in what can be

done to prevent future conduct like Mr. Gruttadauria’s. At the most

basic level, firms are responsible for establishing systems of supervision and internal controls that are reasonably designed to ensure

that their employees are in compliance with the law. Broker-dealers are required, under current law, to have adequate procedures

and controls to identify the kind of sales practices that Mr.

Gruttadauria engaged in, and to conduct regular reviews of their

employees’ activities.

I am pleased to tell you that many firms have in place procedures to help them prevent and detect fraud by brokers. My written testimony that I submitted sets out, in some detail, some of the

procedures that firms can use, including things like verifying

changes of address directly with the customer, confirming customer

authorizations to transfer funds out of their account, paying special

attention to post office boxes and other addresses that are not the

customer’s home address, exercising control over account statements, supervising employees’ use of personal electronic devices,

and providing independent supervision and review of activity by

producing managers. These are, I think, very important.

12

I would like to switch gears for just a minute and briefly address

the SEC’s examination efforts. In one of our examinations in 1993,

as has been raised today, we came very close to Mr. Gruttadauria.

We conducted a cause examination of the Chicago, Illinois, office of

Cowen where Mr. Gruttadauria serviced some of his accounts, after

receiving an anonymous tip that alleged churning (or excessive

trading) in one of his accounts.

While there were some flags that prompted the SEC examiner to

conduct a detailed review of that particular account and other

Gruttadauria accounts in the Chicago office, the examination was

unable to establish sales practice abuse in that account sufficient

to warrant further action. Now, I will say that knowing what we

know now, I wish I could say that we had detected the fraud in

1993.

Well, what has the SEC done in response to this event? As you

would expect, we have worked closely with the New York Stock Exchange and the NASDR to understand the alleged fraud in this

case, and we intend to continue to vigorously prosecute Mr.

Gruttadauria. Together with the SROs, we are focusing particular

attention on examining firm procedures and systems to prevent

fraud of this type in the future.

We have reminded securities firms of the importance of these

procedures, and we will also be conducting a series of examinations

focused solely on firm procedures designed to prevent theft by registered representatives.

We intend to ensure that the best practices that I have described

in my testimony become the universal practices in the securities industry.

I am pleased to answer any questions that the subcommittee

may have.

[The prepared statement of Ms. Lori Richards can be found on

page 69 in the appendix.]

Mr. LATOURETTE. [presiding] Thank you very much, Ms. Richards.

And before I yield to Mr. Doherty, for those of you from Cleveland or Illinois that don’t come here on a regular basis, there is a

15-minute vote on the floor, and so I ran as quickly as I could to

get to the Capitol and come back so we can keep the testimony

going. And our colleagues will come back and join us for the question and answer period.

So I apologize that we are conducting legislative business at the

same time we are doing this, but we wanted to not inconvenience

anybody.

Mr. Doherty, welcome, and we are looking forward to hearing

your testimony.

STATEMENT OF DAVID DOHERTY, EXECUTIVE VICE PRESIDENT FOR ENFORCEMENT, NEW YORK STOCK EXCHANGE

Mr. DOHERTY. Thank you. Good morning, Chairwoman Kelly,

and members of the committee. I appreciate the opportunity to talk

with you this morning about how the New York Stock Exchange

regulates our member firms, and to provide some information

about actions we have taken concerning Cleveland broker Frank

Gruttadauria and others associated with him.

13

Regulation of the securities industry in the United States depends upon self-regulation and begins with the broker-dealer itself.

The Exchange plays a critical role by maintaining an extensive system for monitoring and regulating the activities of its membership

with SEC oversight. The regulatory group of the Exchange currently employs approximately 560 people representing over onethird of the entire Exchange’s staff, with an operating budget of

$142 million.

The Division of Member Firm Regulation, with a staff of 265,

oversees 260 member organizations that employee nearly 160,000

registered persons and service nearly 93 million customer accounts.

That is more than 85 percent of the public customer accounts carried by broker-dealers in the United States.

Our staff conducts annual on-site examinations of every one of

these firms. We visit the main office and approximately 200 branch

offices each year, which are selected using a risk-based analysis.

Our criteria and methodology for selecting branch offices for review

is constantly being upgraded and refined based on experience and

new technology. A more complete description of our exam program

is included in my written testimony.

Serious or repeated violations found by our examiners are referred to the Exchange’s Enforcement Division. The Enforcement

Division, which has a staff of about 136, carries an inventory of approximately 700 cases and initiates over 200 enforcement actions

a year. Enforcement staff conduct investigations often in cooperation with the SEC and decide whether to institute formal enforcement proceedings. Possible sanctions or penalties include censures,

fines, suspensions, or permanent bars from our membership.

The short-term objective of an effective enforcement program is

to catch and punish the people who break the rules. The long-term

objective is to deter other violative activity, induce compliance, and

ultimately enhance investor confidence in the integrity of the market.

I would like to address the matter involving Mr. Frank

Gruttadauria, the former broker for Lehman Brothers and S.G.

Cowen. The Exchange learned of the Gruttadauria matter on January 22 of this year when we were contacted by officials from Lehman Brothers. We responded immediately by putting together a

team of enforcement attorneys and examiners, meeting with the

compliance officials at Lehman, discussing the case with the SEC,

and beginning an investigation.

That investigation, which is ongoing, focuses on the manner in

which Gruttadauria conducted his activities, the supervisory structure and procedures in the Cleveland office, and the overall supervisory structure of both Lehman and S.G. Cowen. The Exchange is

working cooperatively with the SEC’s Enforcement Division in this

investigation.

The Exchange has taken the following actions so far regarding

the Gruttadauria matter. On February 5, two weeks after first

being notified of this matter, we issued charges against

Gruttadauria for misappropriation of customer funds and failure to

cooperate with Exchange investigation. A hearing was held, findings were made that he was guilty as charged, and on March 19

14

he was censured and permanently barred from association with

any New York Stock Exchange member firm.

Also, in February and April, we issued charges against two of

Gruttadauria’s assistants based on their refusal to provide required

information to us. It is worth noting that in 1998 the Exchange

brought formal enforcement proceedings against Cowen for a number of violations. A major focus of the case was improper order ticket procedures, failure to comply with margin requirements, but

other violations included failure to reasonably supervise producing

branch office managers and failure to comply with rules governing

discretionary accounts, among others.

This resulted in a decision by consent in which Cowen received

a censure, a fine of $380,000, and a requirement was imposed that

Cowen correct procedural and supervisory deficiencies. Cowen’s

compliance with the 1998 decision is one of the matters that is

under review in our current investigation.

Since the beginning of this year, the Exchange has undertaken

a number of initiatives focusing on compliance systems and procedures at retail firms. These initiatives were partly in response to

the Gruttadauria matter, but they also reflect our commitment to

continually review, expand, and improve our regulatory program to

adapt to new information and technological advances.

So, we have already permanently barred Frank Gruttadauria.

We are investigating the supervisory structures at the firms where

he worked. We have enhanced our examination procedure, and we

have under consideration adoption of new rules to strengthen investor protection in this area.

Let me assure you of the Exchange’s continuing commitment to

our strong regulatory program. Thank you again for the opportunity to testify today.

[The prepared statement of Mr. David Doherty can be found on

page 79 in the appendix.]

Mr. LATOURETTE. Mr. Doherty, we thank you very much for your

testimony.

The schedule indicates that other members of the panel, including the Chairman, will be back shortly. And so in light of the fact

that there is great interest in asking questions of everyone who has

testified so far, I think it is the Chair’s predisposition to take a

short recess. If you could not wander too far, so that when Mrs.

Kelly comes back we don’t have to gather people from the far

reaches of the building, I would appreciate that.

And the subcommittee will stand in recess, subject to the call of

the Chair.

[Recess.]

Chairman KELLY. [presiding] Is Mr. Doherty in the room? Absent

Mr. Doherty, I think we will go ahead with some—with the questions. I would like to ask some questions of you, Ms. Richards.

Ms. Richards, on page 5 of your testimony, you refer to firm practices to prevent and detect fraud. One of these policies is, and I

quote, ‘‘special attention to P.O. boxes.’’ Now, we are aware that

this was a key way in which Mr. Gruttadauria was able to perpetuate his scam. Is this policy a requirement of the SEC or just a

suggestion?

15

Ms. RICHARDS. I guess I think that under a broker-dealer’s existing duty to supervise, they have an obligation under existing rules

and regulations to make sure that their supervision is adequate.

And use of P.O. boxes has been found not only in this case, but also

in other cases, to facilitate fraud by registered representatives.

This is not the first time that this P.O. box trick has been used.

So in light of that, I think that broker-dealers must, under existing obligations to supervise, pay special attention to the use of P.O.

boxes. And there is nothing inherently wrong with the customer

using a P.O. box. Many customers in rural areas, for example, use

a post office box. But when a firm sees that a customer has a post

office box, they ought to pay special attention to ensuring that the

customer has truly authorized the firm to use the P.O. box.

Chairman KELLY. Perhaps, Ms. Richards, it might be a good idea

if the SEC took another look at some kind of oversight on the use

of P.O. boxes. Would you agree?

Ms. RICHARDS. Absolutely. And that is exactly what we are doing

now. Immediately after the Gruttadauria case broke, we met with

the New York Stock Exchange and the NASD and decided to pay

collectively, as securities regulators, special attention on these

what I think are very basic compliance procedures designed to prevent theft.

So in all of our examinations going forward, we intend to focus

on firm procedures, not only in this area but in the other areas

that I have identified in my testimony. If through that process we

determine that additional rules or regulations are appropriate, we

intend to alert the Commission to that early, and to work closely

with the self-regulatory organizations in determining whether or

not additional rulemaking is appropriate.

Chairman KELLY. So, once again, though, you are looking at allowing the firms themselves to govern what is happening with regard to the relationship of the post offices boxes with regard to

their clients and the delivery of the statements for the accounts. Is

that correct?

Ms. RICHARDS. Firms have an existing duty to supervise, and

this is an area where they have got to pay, in my view, enhanced

attention—compliance attention—to. They have got to scrutinize

use of post office boxes carefully. I don’t think it would be appropriate for regulators to prohibit the use of post office boxes, as I

said, because many customers in rural areas in particular need to

use post office boxes.

But when the firm sees that a customer has a P.O. box, or an‘‘in

care of’’ address, or any address other than their home address,

they need to pay particular attention to that.

Chairman KELLY. Well, let us go to an exam that was conducted

by your examiner in 1993. You mentioned it on pages 4 and 5 of

your testimony. That they did not contact the customer that was

involved. Is it a normal practice to contact the customer when the

account is being examined?

Ms. RICHARDS. It is a judgment call that is made by the examiner, based on the facts that are developed during the examination.

If I could, I would like to describe to you in a little bit more detail

what happened in the 1993 exam.

16

Chairman KELLY. Prior to your description, I would like to simply say that I understand this was done in December of 1993, that

it was signed off by five supervisors, there is five signatures on

that. I also would like you to submit that for the record within the

next 24 hours. Will you please comply with that request?

Ms. RICHARDS. We have made the entire examination report

available.

Chairman KELLY. No, ma’am. I want it submitted for record.

Ms. RICHARDS. I would have to go back to our Commission and

ask for authority to do that.

Chairman KELLY. Will you please do that?

Ms. RICHARDS. Yes, I will.

Chairman KELLY. Proceed with what your explanation was.

[The following information was subsequently furnished by Ms.

Lori Richards for the hearing record.]

Ms. RICHARDS. In 1993, the Commission received an anonymous

complaint about a customer’s account that was maintained by Mr.

Gruttadauria. The anonymous complaint alleged that there was

churning in the account, and churning is simply excessive trading,

trading that is not appropriate for the particular customer. It is designed to provide the registered representative with commissions,

but involves trading that is not appropriate for the customer.

Based on that anonymous complaint, the Commission went in—

examiners in Chicago went in to Cowen’s Chicago office and conducted an examination focused primarily on that particular account. They examined the account statements that were provided

not by Mr. Gruttadauria but by the firm itself, and the examiner

noted that the trading was very significant. There was a lot of trading in the account during a six-month period three years before the

examination.

The fact that there was frequent trading, in and of itself, while

it is a red flag, it is not in and of itself violative, because many customers engage in frequent trading. So what the Commission then

does, after it noted that there was such frequent trading, in fact,

the examiner computed a turnover rate in the account of 18 times.

That is very significant. That is a lot of trading.

So with that information, the examiner then looked at whether

or not the trading was indicative of a violation of the law. And the

elements of a churning violation are really just two. First, is the

trading excessive for that particular customer? And then, second,

does the registered representative have control over that particular

account? So the turnover ratio is just one part of the analysis.

The next step was to review the background of this particular investor. The account documents that were provided by the firm, not

by Mr. Gruttadauria but by the firm, indicated that this was an experienced investor. This was someone with a very significant net

worth of about $5 million and with 10 years or so of trading experience in equities and options. Based on that, it appeared to the examiner that this was an experienced trader, an experienced investor.

The next step was to review who was directing the trades, because this is an element in a churning charge—the trades must

have been directed by the registered rep. Based on the registrant

and Mr. Gruttadauria, the examiner was told that the trades were

17

unsolicited. That is, that the investor herself was directing the

trades.

The Commission’s examination procedures at that time would require the examiner to confirm that statement by looking at the

order tickets.

The next step was to review other customers’ accounts, because

what we often find is that when a registered rep is engaged in

churning one account, they will churn other customers’ accounts.

So we looked at a sample of Mr. Gruttadauria’s other accounts in

the Chicago office and found no indications of churning. We also—

Chairman KELLY. May I—I am sorry to interrupt you, but the account information that Mr. LaTourette has submitted for record

today indicates that there was at least one account, if I am looking

at it correctly, that was churned, in 1993, had a turnover ratio of

34 percent. He made a 99 percent commission rate on that.

In 1995, which was post this examination, there were some other

really egregious types of churning here that should certainly but

the ratio of 34 certainly ought to have had a red flag in 1993. I

am going to interrupt your testimony here, but just because I have

a question. I am going to run out of time, and I need to talk to Mr.

Doherty. I am going to go—I would like to go back to you. I will

go back to you. So stop yourself where you are, and we will come

back.

I want the rest of the—I would like you to read into the record,

or state for the record, exactly what happened in the 1993 exam.

But I also want to caution you that the committee would expect a

response from your organization within the next 24 hours regarding that report.

Mr. Doherty, I wanted to ask you just one question, and I will

come back to you. On page 13 of your testimony, you mention your

1998 enforcement action against Cowen for, among other things,

and I am quoting— ‘‘the failure to reasonably supervise branch office managers acting in the capacity of registered representatives.’’

And then you also mention on page 14 of your testimony—and,

again, I am quoting—‘‘in 1999, outside counsel concluded in its report to the Exchange that Cowen had satisfied its undertaking in

all material respects and made significant efforts in addressing

areas of deficiency.’’

I would like you to try to discuss what steps were taken to improve the supervision of branch office managers at that point, and

any reasons that you are aware of that this improved supervision

didn’t detect Mr. Gruttadauria’s actions. These people were defrauded. These people have lost their life savings.

Mr. DOHERTY. They certainly have. The enforcement proceeding

that we brought in 1998 we considered to be a very significant one.

There were a number of violations involved. A small part of it related to failure to supervise producing branch office managers in

the 1995 exam in one of the New York offices.

We were sufficiently concerned with the supervisory deficiencies

in that case that we not only imposed a significant fine, but we required, as a part of the settlement that Cowen entered into that

a consultant be appointed who would come in and look at the systems and procedures that Cowen was putting in place and make

18

an evaluation as to whether those systems and procedures, as enhanced, were adequate.

And the consultant—it was an outside law firm—did that and

filed a report and represented that they had confirmed that a number of enhancements had been made, such as the firm had appointed a senior person full-time whose job was to supervise producing branch office managers.

There was an indication and confirmation that the firm had developed a process where a detailed questionnaire would be sent out

to branches required to be answered by the firms, and it got into

areas that are involved here dealing with LOAs and post office

boxes. That was supposed to be, under the procedures, followed up

twice a year by branch office visits from this new supervisory structure that was put in place.

There was also a representation that the branch office manager’s

correspondence would be put in a separate file that would be reviewed monthly. And there was a general representation that all

of the procedures put in place now had adequately enhanced supervision. There was a representation that the Compliance Department had enhanced supervision generally by, among other things,

adding resources.

So one of the things that we are looking at carefully in our investigation now is whether these procedures were number one, actually put in place; number two, if put in place, maintained; and,

number three, even if the procedures were put in place, were they

adequately implemented? Sometimes we see procedures, and they

are a great looking set of procedures, but implementation is not

carried out.

So this is what we are looking at now in the course of our investigation. We required this enhanced review as a part of that enforcement proceeding, and we received assurances not only from

the outside law firm, but the report was filed and it was certified

by both the Board of Directors and the CEO that these procedures

had been put in place.

Chairman KELLY. Thank you, Mr. Doherty.

Mr. DOHERTY. Now, we are concerned that in light of this, the

Gruttadauria activities were continued, and that is very much the

focus of our investigation.

Chairman KELLY. Thank you, Mr. Doherty. One of the things

that really concerns me about this case is it hasn’t been just Mr.

Gruttadauria. There have been other cases. We need to do as much

as we can to have you do what you need to do to put the public’s

trust back into the system.

So with that being said, I am going to turn to my colleague, Ms.

Tubbs Jones.

Mrs. JONES OF OHIO. Thank you, Madam Chairwoman.

Mr. Fazio, unfortunately, we only have five minutes to question.

But it would be a shame that you wouldn’t have a couple—another

opportunity to be heard, at least briefly. Can you tell me, looking

back, sir, what was it that engendered Mr. Gruttadauria to you?

If we were going to talk to other senior citizens like you and Mrs.

Stout, what would you tell them to look out for?

Mr. FAZIO. Do you mean now that—

Mrs. JONES OF OHIO. Yes, sir.

19

Mr. FAZIO. —this happened?

Mrs. JONES OF OHIO. Looking back, in hindsight, sir.

Mr. FAZIO. Well, I would say that you need to talk to somebody

above the branch manager in New York and check if, in fact, any

brokerage company person ever called any investor when there was

an address change to check it out, and to be careful because things

can be done with these phony statements that we are learning and

we know now.

And did any person ever call any customer? I never got a call

from anyone else. I never did. And these numbers were changed,

and my signature was forged, and so forth, to change them. Never

got a call from anyone, and I didn’t know what was going on. I

really didn’t. I didn’t know that these box numbers even existed

until now, until all of this—everything came up.

Mrs. JONES OF OHIO. But there was something about Mr.

Gruttadauria that caused you to place some trust in him. But what

I am asking you is: with regard to personality, or whatever, what

would you say to another senior citizen who might have been—

might be contacted by a broker?

Mr. FAZIO. Well, I would say that sometimes you have got to

watch your closest friends. He was a very close friend. I told you

I treated him like he was my son. That is how close we were.

Mrs. JONES OF OHIO. Okay.

Mr. FAZIO. And you have got to be careful, and that is all you

can do.

Mrs. JONES OF OHIO. Okay.

Mr. FAZIO. But mainly is that companies themselves have to

check out their people. You know, you can’t do it with the compliance officer, as I pointed out, in the same office reporting to the

manager. You have got to do it where the compliance officer reports

to somebody else above the manager, somebody in New York to

check all these things out.

Mrs. JONES OF OHIO. Thank you.

Mrs. Stout, a short answer if I could get one from you as well.

Go ahead.

Mrs. STOUT. Well, I wish that I had been smart enough to analyze why did I have checks with DeGrandis for the signature. Now,

it should have been Lehman or Cowen. Instead, it was someone

else. I had my own tax person. Why would I be having that firm

as a tax representative?

Mrs. JONES OF OHIO. For the record, tell people who DeGrandis

is, Mrs. Stout.

Mrs. STOUT. Well, I think that they are a tax firm working in

Ohio.

Mrs. JONES OF OHIO. Well, this was someone that Mr.

Gruttadauria represented or expected that you might use for your

tax purposes, an attorney in Cleveland, right?

Mrs. STOUT. He might have, but I was—never even hinted to say

I would like to have or needed—

Mrs. JONES OF OHIO. Okay. Anything else you would say to other

seniors who might be considering doing some investment, what

they should look out for from your own perspective?

Mrs. STOUT. Well, when they start saying—I wanted to have online for my—so I could watch each day. When I called to ask, he

20

said, ‘‘Oh, no, we do not do that. I will not be harassed.’’ When you

start having—saying, ‘‘I won’t do this. I won’t do that,’’ that is a

red flag. Watch. And in the future, don’t have that person—he said,

‘‘If this is the way that you feel so strongly, then I will get you another broker.’’ I was—

Mrs. JONES OF OHIO. And you should have said, ‘‘Then, get me

another one,’’ right?

Mrs. STOUT. Well, and so what I should have done—you know,

I kind of hemmed and hawed there for a minute, and he said, ‘‘I

will tell you what I will do. I will send you the symbols, but this

is against my principles.’’

Mrs. JONES OF OHIO. Okay.

Mrs. STOUT. You know what? It isn’t his principles, it is mine,

that I should be thinking about. And that was a mistake. You know

what? You should come back on your own intuition. I did not. I

was—I am like Carl. I thought he was like my son, and I trusted

the firm. After all, it is a good firm. I thought he was in Chicago.

I never knew that he was in Ohio. Had no idea.

He visited me, told me about—took me out for dinner, told me

about the one daughter that was a candy striper at—

Mrs. JONES OF OHIO. He drew you in, in other words. He drew

you in to his confidence.

Mrs. STOUT. Oh, honey, he was right there.

[Laughter.]

Mrs. JONES OF OHIO. Thank you, Mrs. Stout.

Let me go to Mr. Doherty from the New York Stock Exchange.

Can you tell us how often brokerage firms incur charges like the

one that was brought against Cowen & Company in 1998 with regard to failure to supervise branch manager officers, etcetera?

Mr. DOHERTY. Well, let me answer more broadly.

Mrs. JONES OF OHIO. Okay.

Mr. DOHERTY. In a typical year, our enforcement program will

bring about 200 formal enforcement proceedings. The large majority of those charged are individuals. But in a typical year, I would

estimate 20 or 25 member firms themselves are charged as Cowen

was in the example we have heard about.

Mrs. JONES OF OHIO. And of the—go ahead. I am sorry.

Mr. DOHERTY. Well, those charges range all the way from purely

financial and operational kinds of things, a net capital violation, for

instance, to, in some cases, inadequate supervisory procedures. And

then some of the inadequate supervisory procedures cases relate to

sales practice issues.

Mrs. JONES OF OHIO. Well, a firm signs up to be part of the New

York Stock Exchange, what commitments do they make?

Mr. DOHERTY. Well, they make a commitment to not only abide

by the federal securities laws, but they make a commitment to

abide by the New York Stock Exchange’s rules, which really impose

on the firms not only a variety of particular rules but, importantly,

our rules require that our firms operate consistent with ethical

standards. So that it is a level of conduct which could be violated

that doesn’t reach a violation of the federal securities laws.

So our rules require such things as—or preclude conduct inconsistent with just and equitable principles of trade, and the like,

ethical standards.

21

Mrs. JONES OF OHIO. Do you have subpoena power as the New

York Stock Exchange?

Mr. DOHERTY. We don’t—

Mrs. JONES OF OHIO. To your members.

Mr. DOHERTY. We don’t have subpoena power, but—and our jurisdiction is limited to our members and employees, people associated. But we—

Mrs. JONES OF OHIO. So if I fail to agree to provide you information or cooperate, what do you do to me?

Mr. DOHERTY. Well, with respect to the people we have jurisdiction over, we have something better than—

Mrs. JONES OF OHIO. That is what I meant, if I were a member.

Okay.

Mr. DOHERTY. And that is we have a rule that requires that our

members and people associated comply with our reasonable requests for information in our investigations and that is the provision which we have used to charge three people in this particular

investigation. We use it often, and the usual consequence is that

people are barred from the industry until they comply or perhaps

barred after a certain period of time if they don’t. So there are significant consequences.

Mrs. JONES OF OHIO. Two shorter questions with hopefully shorter answers. You have heard Mr. Fazio, Mrs. Stout, and others say

that the reason they invested with these companies was because of

their reputation long term. Do you, as the Stock Exchange, treat

people who have been long-term members any differently than you

treat newer members to the Stock Exchange?

Mr. DOHERTY. No. We apply the same standards to everyone. We

sue the big firms and the small firms equally.

Mrs. JONES OF OHIO. Do you treat sanctioned firms any differently than you treat non-sanctioned firms?

Mr. DOHERTY. The fact that a person or a firm had engaged in

violative activity previously would be considered in the size of the

sanction or punishment that would be imposed if there was another

violation.

Mrs. JONES OF OHIO. For example, in ’98, when you sanctioned

Cowen & Company, what was the follow up after that sanction?

Mr. DOHERTY. Well, we haven’t—that is the last enforcement

proceeding—

Mrs. JONES OF OHIO. Okay.

Mr. DOHERTY. —that we initiated against Cowen to my knowledge.

Mrs. JONES OF OHIO. But who, then, is responsible for overseeing

whether or not they have complied with the sanction that you impose?

Mr. DOHERTY. Well, in the first instance, the firm has a continuing responsibility to, under our rules, and as Ms. Richards

said, to run their business operation in a way that complies with

the rules. Secondly, our examiners will typically go back into a

member firm in the follow-on years where they have found problems to do a review to ensure that the problems have been corrected.

Mrs. JONES OF OHIO. Did you go back to Cowen after ’98?

Mr. DOHERTY. Yes. We went—

22

Mrs. JONES OF OHIO. And who went back? And what did you

find?

Mr. DOHERTY. Our examiners went back in and reviewed for

compliance with many of the exceptions that were found, and they

found no deficiencies that they felt were worthy of referring to the

enforcement program.

Mrs. JONES OF OHIO. I am out of time, but I—we are going to

have another round. Is that correct?

Chairman KELLY. We will see if that is possible.

Mrs. JONES OF OHIO. Because I have a lot of questions for Ms.

Richards, but thank you, Madam Chairwoman.

Chairman KELLY. Ms. Tubbs Jones, I am going to hold the record

open for 30 days for questions and submitted answers for all members of the committee, because some of the members can’t be here

today. So by all means, if you have further questions of this panel,

you may submit them, and we can expect their responses within

30 days. So feel free to do that, if we are not able to do a second

round here.

We turn now to my colleague, Mr. Ney. Mr. Ney, are you ready?

Mr. NEY. Thank you, Madam Chairwoman.

I had a question, Mr. Doherty. A securities attorney quoted in

the Cleveland Plain Dealer story said that a turnover rate of six

times a year should raise a red flag, and that was reported in the

PD. In your opinion, if the SEC could have told you the level of

commissions and a turnover rate of 18 times in six months, do you

think the Exchange might have wanted to take a more closer look

at Gruttadauria’s accounts?

Mr. DOHERTY. I think that we would have—it would have been

a red flag, and it would have been something that we would have

looked at carefully. I can’t tell you that we would have done it any

differently from what the SEC did. In hearing Ms. Richards’ testimony, it sounds as though they brought to bear the same kind of

analysis that we would have.

Mr. NEY. Another question I had would be for Ms. Richards and

Mr. Doherty. Mr. Gruttadauria apparently created these phony account statements on his own computer outside of the office system.

How can that be prevented in the future, that they could be—or

can it? Just some thoughts from both of you on that.

Ms. RICHARDS. One of the things that we recommend in our testimony is that broker-dealer firms maintain very tight control over

blank account statements and other account documents of the firm,

so that registered representatives and other unauthorized employees can’t get hold of them, doctor them up, and send them out.

Another thing that many firms are doing now is creating account

statements that are very difficult to duplicate. They have

holograms or watermarks or special indicia on the original, so that

it makes it easier to detect a forgery. So I think control over the

actual sending of the account statements by brokerage firms is terribly important.

Mr. DOHERTY. If I could add that in 1999 we added an element

to our exam program that required our examiners to do a careful

review of this very area, to look to see whether there were any personal computers being used by any salesmen in the office, and to

23

do an examination of what procedures the firms had in place to supervise the use of those personal computers.

And that is an area we are very much concerned about with electronic communications and use of the internet by registered reps,

and we have brought a bunch of enforcement cases against registered reps in that area. This is something that we did at least

two or three years ago in terms of extending our exam program.

Mr. NEY. The other question I wanted to ask someone I guess—

if people are receiving false statements for a number of years, and

they have prepared their taxes, wouldn’t Lehman Brothers have to

send notification of earnings, and, therefore, the people overpaid

their taxes that are sitting here? I don’t know who wants to reflect

on that, but—

Mrs. STOUT. I don’t really see how it could be. I received the

1099s, my monthly statements—

Chairman KELLY. Ma’am, please turn on your microphone. Somehow it has gotten turned off. Pull it closer to your mouth, and then

we can all hear what you say.

Mrs. STOUT. All right.

Chairman KELLY. Thank you.

Mrs. STOUT. I did receive the 1099s, my monthly statements.

There was no other way that I figure that I could have been alerted.

Mr. NEY. Well, I guess my question—and probably maybe the

other panel can answer it—my question is geared towards if

you’re—you know, you’re receiving these false statements. Lehman

Brothers, I assume, had to be responsible for notification to IRS of,

you know, the real account. So, therefore, you know, I guess there

was no IRS catching the difference, which would have alerted you

early. I guess there is no mechanism.

But, obviously, Lehman Brothers had to have sent those in. Isn’t

that correct? Isn’t that the way it works? So it would have showed

to the IRS, you have Mrs. Stout, here is how much she made, but

she shows she made—and over a period of 10 years or nine, surely

that should have gotten caught somewhere, I would assume, by

IRS.

Mrs. STOUT. Well—

Mr. NEY. Although maybe I shouldn’t—

Mrs. STOUT. —maybe I could come back and say now I had

Microsoft, I had Cisco. That was—it would grow. I had—I started

out with 750 shares. When I got my last statement, I had 12,000

of one and 27,000 of another, which showed that I had all of that,

but it wouldn’t show on my income tax, because it was still in the

firm, and not—

Mr. NEY. I have gone past my time. Maybe later on somebody

can clarify, was he sending false statements to Lehman Brothers,

to the IRS? No. Right? Yes? No.

Chairman KELLY. Go ahead and ask that question. I will give

you—

Mr. NEY. Thank you. If you could—

Chairman KELLY. —a little more time. Ms. Richards, if you could

answer that.

Ms. RICHARDS. I was just going to say our investigation is ongoing. I think if the firm was sending accurate 1099s to the addresses

24

on file, for many of these customers those were post office boxes.

So they would not be getting the accurate 1099s.

Mr. NEY. But they went to the IRS.

Ms. RICHARDS. Yes.

Mr. NEY. Right?

Ms. RICHARDS. Yes. I would think that—yes.

Mr. NEY. So it should show different what Mrs. Stout was reporting from the false—and then what the IRS was getting from Lehman Brothers. It should show a difference, I think.

Ms. RICHARDS. There would be a discrepancy. I just don’t—I

don’t know what the IRS—

Mr. NEY. I mean, it is important to know whether that—I mean,

I feel sorry for these people that have been burned. I am just wondering what system should have caught that.

Thanks very letting me exceed my time.

Chairman KELLY. Perfectly all right. It is a legitimate question.

It needs answering. It raises a lot of issues, and it is probably part

of the ongoing judicial investigation.

Now we go to Mr. LaTourette.

Mr. LATOURETTE. You caught me by surprise, Madam Chairman.

I thought Mr. Cantor was still here.

Mrs. Stout, since this story broke, has anyone other than Mr.

Gruttadauria from Lehman Brothers come to visit you in Elgin, Illinois?

Mrs. STOUT. Yes. I had representatives of Lehman.

Mr. LATOURETTE. Right. Can you tell us about that exchange or

what happened when they came to see you?

Mrs. STOUT. I beg your pardon?

Mr. LATOURETTE. What was the purpose for which they came to

visit you, and what happened?

Mrs. STOUT. Well, I had called the office and wanted to have an

explanation, and they, I assume, decided they wanted to come I

think maybe to check to see if I was going to be an easy customer,

if they would be able to hoodwink me, and I—and they left. I had

no information from them.

Mr. LATOURETTE. Did you ask them about your money? I mean,

what—

Mrs. STOUT. Oh, yes, I did. And I asked if there was a chance

that I would be getting it back.

Mr. LATOURETTE. And what did they tell you?

Mrs. STOUT. No answer.

Mr. LATOURETTE. Okay. When Mr. Fazio comes back, I have a

couple of questions for him.

But, Ms. Richards, I am going to ask my legislative assistant to

hand you a document that the Chairwoman was talking to, and

this is—when you were indicating before the—and, Mrs. Stout, just

back to you, Mrs. Cuneo is your sister, right?

Mrs. STOUT. Yes.

Mr. LATOURETTE. Your sister.

Mrs. STOUT. Yes.

Mr. LATOURETTE. And that was—Mrs. Cuneo’s account was the

subject of the 1993 complaint, Ms. Richards, is that the anonymous

complaint, the—

Mrs. STOUT. I am not sure, but it could be.

25

Mr. LATOURETTE. I am asking Ms. Richards. Cuneo was the investor involved in the 1993 anonymous complaint?

Ms. RICHARDS. The identity of the accounts that we examine are

typically not public.

Mr. LATOURETTE. Right. But they will be when you comply with

Mrs. Kelly’s request. And I think it is Mrs. Stout’s sister that was

ripped off in 1993, and we will determine that.

I have put in front of you a document that is an account belonging to a fellow by the name of Dominic A. Visconsi, Sr., and it goes

from ’92 to ’96. And at the bottom—I think Mr. Ney asked you—

it is my understanding under federal law, and also S.G. Cowen’s

own internal manual, that a turnover ratio of six gives rise to a

conclusive presumption of excessive trading or churning. Is that

your understanding, or am I mistaken?

Ms. RICHARDS. We would actually look very hard at any account

that had a turnover ratio of less than six. We would look at an account that had a turnover—an annualized turnover ratio of two to

three. We would then focus hard on those accounts.

Mr. LATOURETTE. What about the ones that are turned over

more than six times?

Ms. RICHARDS. Well, certainly, those would trigger our attention.

Mr. LATOURETTE. Well, in the document I have put in front of

you, in 1992, Mr. Visconsi’s account, with an average equity of

$416,000, was charged commissions of $113,000, and turned over

18 times. Would you consider that to be unusual activity worthy of

your examination, had you known about it?

Ms. RICHARDS. Absolutely.

Mr. LATOURETTE. And, likewise, in 1993, average equity of $447,000, commissions of $221,000, and a turnover ratio of 34

times. I would imagine that would grab your attention as well, had

you known about it.

Ms. RICHARDS. Yes.

Mr. LATOURETTE. And, Mr. Fazio, I have had a chart made of an

account that your lawyer was kind enough to give me last night.

If we could put the chart up on the easel. It is your account 00-

00068. And the year that we have highlighted is 1990, and I would

just like you to take a look at it. And, one, does that look familiar

to you? Do I read it right that, in 1990, your account had an average equity of $103,000 roughly, that the commissions charged on

it were $67,471.70, and the turnover ratio was a little over 15

times, is that a correct reading?

Mr. FAZIO. That is correct.

Chairman KELLY. Excuse me. I want to know if you would like

to have that entered into the record.

Mr. LATOURETTE. Yes, please.

Chairman KELLY. So moved.

[The following information was subsequently furnished by Mr.

Carl Fazio witness] for the hearing record.]

Mr. LATOURETTE. And, Ms. Richards, likewise, with the Visconsi

account, and we are, again, in the same time period as your investigation in 1993 of the account we believe was owned by Mrs.

Stout’s sister, would you find the information that is on that board

to be worthy of your attention and examination?

Mrs. STOUT. I am sorry. I did not—

26

Mr. LATOURETTE. No, no, I was talking to Ms. Richards. I am

sorry, Ms. Stout.

Ms. RICHARDS. We would definitely scrutinize an account with

that kind of turnover ratio. I think it is important to note that we

focus on firms’ exception reports, which would typically flag accounts with turnover ratios of certainly that high. And then we

would drill down and focus specifically on those accounts.

So if the firm’s exception reports were accurately identifying accounts with those kinds of turnover ratios, we would drill down

very hard and focus on them.

Mr. LATOURETTE. And, lastly, let me ask you, it is my understanding, in response to the questions by the Chairwoman, that

your investigators made a judgment call not to talk to the investor

in 1993 in that investigation. And basically—and, Mrs. Stout, let

me come back to you, who was the executor of your sister’s estate?

Do you recall?

Mrs. STOUT. Frank.

Mr. LATOURETTE. Frank Gruttadauria. Doesn’t that create sort

of, Ms. Richards, a closed loop? If you go and you talk to Mr.

Gruttadauria, who apparently is trusted by people like Mr. Fazio

and Mrs. Stout, and apparently her sister, and you have an account that has been turned over 18 times in six months, charged

commissions of $39,000 on an equity of $96,000, does due diligence

or an appropriate investigation stop with a guy like Frank

Gruttadauria? I mean, don’t we have an obligation to go out and

talk to somebody else besides the thief?

Ms. RICHARDS. Well, again, focusing on the information that the

examiner had before him at the time, it was a judgment call. And

one of the critical factors that the examiner relied on was whether

or not the investor that owned the account had complained. And,

in fact, this investor had never complained about the trading in her

account.

Looking back on it now, with all that we know about what Mr.

Gruttadauria did and what he was capable of, yes, I certainly wish

we would have talked to the customer. But, I mean, now, looking

back, I don’t know what the customer would have said.

Mr. LATOURETTE. Of course not.

Ms. RICHARDS. Truly, I don’t know if, looking back on it now, if

the customer wished to engage in frequent trading and herself directed the trading, as we were told by the firm.

Mr. LATOURETTE. But I think if you put the ’93 account together

with the Visconsi account together with the Fazio account, I mean,

something smells pretty bad here, and perhaps we should have

talked to additional people. And I had a question and now it is out

of my head.

Mrs. Stout, back to you, let me—when Lehman Brothers visited

you, did you have the impression that it was an attempt to get you

to settle any claim you might have against them?

Mrs. STOUT. No.

Mr. LATOURETTE. Okay. Did they inquire as to whether or not

you were represented to counsel, whether you had a lawyer?

Mrs. STOUT. I had not had a chance to get counsel.

27

Mr. LATOURETTE. Okay. And lastly, Ms. Richards—and I appreciate the Chair’s indulgence—was the investigation conducted in

1993 shared with S.G. Cowen?

Ms. RICHARDS. S.G. Cowen compliance personnel were in the

room when we interviewed Mr. Gruttadauria, and when we asked

questions about the accounts and the exception reports. So they

were very well aware of what we were focused on.

Mr. LATOURETTE. Would your investigative file have been available to Lehman Brothers when they were conducting their due diligence when they purchased the retail business of S.G. Cowen in

the year 2000?

Ms. RICHARDS. No, because the examination didn’t result in conclusive findings of violations. There was no deficiency letter sent to

the firm.

Mr. LATOURETTE. Would your investigative file have been shared

with Mr. Doherty in the Enforcement Division of the New York

Stock Exchange?

Ms. RICHARDS. We share examination reports with the SROs

whenever it’s relevant for either party. But in this case, it wasn’t.

Mr. LATOURETTE. And I was going to ask Mr. Doherty, before

reading it in the newspaper, being advised during the course of

these proceedings, any idea that Mr. Gruttadauria had been the

subject of this anonymous complaint in 1993?

Was there any idea by you, Mr. Doherty, that Mr. Gruttadauria

had been the subject of this 1993 complaint?

Mr. DOHERTY. Not to my knowledge, no.

Mr. LATOURETTE. Thank you very much, Madame Chairman.

Chairman KELLY. Thank you. Mr. Inslee, do you have questions?

Mr. INSLEE. If I may, Madame Chair, I’d like to yield to my colleague from Ohio my time in this regard. She’s been doing excellent

work on it.

Chairman KELLY. Thank you.

Ms. JONES. Thank you, Mr. Inslee. I want to start and continue

the line of questioning from Mr. LaTourette, Ms. Richards.

In 1993, you got an anonymous complaint. You went and reviewed the record. Under all anonymous complaints, is it that you

never talked to the customer?

Ms. RICHARDS. No, that certainly is not the policy. I think our

policy currently—

Ms. JONES. Take me back to 1993, not currently.

Ms. RICHARDS. In 1993, our policy would have been to contact a

customer if there were any loose ends, if there was any indication.

Ms. JONES. But who better than the customer than to tell you

or to signal to you of some difficulty?

Ms. RICHARDS. Well, in fact, the examiner made the decision not

to contact the customer because he was focused on the fact that the

customer had never complained to the firm, the fact that the trades

appeared to be directed by the customer and the fact that this customer appeared to be an experienced trader.

Ms. JONES. Appearances are deceptive. Would you agree with me

on that, Ms. Richards?

Ms. RICHARDS. This was according to the new account form that

the customer would have filled out with the brokerage firm. The

28

customer would have indicated to the brokerage firm his or her net

worth, his or her investment experience, his or her investment—

Ms. JONES. Back up a minute. You said it appeared that the customer signed the form. What I’m trying to get to is appearances are

deceptive. We’re sitting here with people like Mr. Fazio, Mrs. Stout,

Mr. Glazier. Under the appearances invested with Mr.

Gruttadauria, you were the examination folk. It’s incredible to me

that—I’m a former prosecutor, you’re an examiner. You go after the

witnesses. The best witness would be the customer that you would

talk with them to find out in any instance, would it not be?

Ms. RICHARDS. Sitting here now, I wish we would have called the

customer, absolutely. I don’t know what the customer would have

said.

Ms. JONES. We never know what anybody is going to say.

Ms. RICHARDS. But sitting here now, I certainly wish we would

have talked to the customer, yes.

Ms. JONES. So now the rules, seeing as we’re now trying to get

so instances like this don’t happen again, you talk to the customer

now?

Ms. RICHARDS. Yes, we have a much more liberal policy on when

the government contacts the customer about a particular account,

absolutely.

There’s another change, if I could—

Ms. JONES. Please.

Ms. RICHARDS. There’s another change in the law that I think

will be helpful in preventing similar situations like this. Under new

rules that were adopted by the Commission a couple of months ago.

The information that I described on a new account form about the

customers’ name, address, investment objectives, net worth, that

information now will have to be sent to the customer for

verification, so that will prohibit a registered representative from

falsifying information on the new account form and I think that’s

a terribly important—

Ms. JONES. It won’t prohibit falsification.

Ms. RICHARDS. Well, the registered representative will be out of

the picture. The firm will send that statement to the customer and

the customer can look at it and say—

Ms. JONES. Where does the firm get the customer’s address?

Ms. RICHARDS. The firm would get the customer’s address from

the customer.

Ms. JONES. So you’re saying that every firm now will have a direct contact with a customer even though there is another representative involved in the process?

Ms. RICHARDS. Yes, the firm itself will communicate directly with

the customer and the customer will then be able to verify yes,

that’s my name, that’s my address or no, it’s not or that’s not my

investment objective, that’s not my net worth. It will make it much

more difficult for registered reps to lie about those things—

Ms. JONES. And what caused you to make this rule change in the

last two months?

Ms. RICHARDS. It had been in the works for some period of time.

We worked very closely with the state securities regulators who

suggested to us that this was a change that needed to be made to

29

prevent theft by brokers. The Commission agreed with it and made

the change a couple of months ago.

Ms. JONES. What other changes have you made to assure an investing public that you are going to do your job?

Ms. RICHARDS. Well, there’s another change imposed in the same

books and records rule that I think Mr. Fazio alluded to and that

is the protection against registered representatives opening post office boxes in their control. The new rule would require that brokerage firms send a change of address confirmation to the old address

and the new address. That, I think, will go a long way towards preventing registered representatives from creating these fictitious

post office boxes, because the customer will get a notice from the

firm that says have you or have you not changed your address to

a post office box? I think that’s an important protection.

Ms. JONES. Did you see all of these events that are occurring and

I look at them, oh wow, okay—I can finish that question or not?

No, okay, I won’t. I’ll go back.

Chairman KELLY. Mr. Tiberi. We’ll let you hold that thought and

come back.

Mr. Tiberi.

Mr. TIBERI. Thank you. Thank you, Madame Chairwoman. Just

a couple of questions. Ms. Richards, of your total investigative force

meaning like attorneys, investigators, supervisor attorneys, senior

trial counsels, how many are employed in the Northeast Region in

New York?

Ms. RICHARDS. The Northeast Region is comprised of both enforcement attorneys as well as examiners and accountants who

conduct examinations of broker dealers, investment advisers, and

investment companies. I don’t know offhand the total number of

staff in the New York office, but I’m happy to provide that to you.

Mr. TIBERI. That would be great. My understanding is is that the

bulk of the employees who do criminal investigations, the staff attorneys are located here in Washington, D.C. and they’re sent out

rather than having a stronger presence throughout the United

States. And it would seem to me that maybe that has created a

problem.

Ms. RICHARDS. We have 11 regions and districts in major metropolitan centers which are staffed by not only enforcement attorneys

who bring enforcement cases, but also in my office, by examiners

and accountants who conduct examinations of registered firms in

their regions and districts.

Here in Washington in the examination program, we have a staff

of about 100 accountants, examiners and attorneys who also conduct examinations and assist in the examinations conducted by the

field offices.

Mr. TIBERI. You’ll provide that information to us?

Ms. RICHARDS. Sure.

Mr. TIBERI. Thank you. Ms. Stout, you mentioned in your testimony that with respect to on-line services that Mr. Gruttadauria

was dissuading you from, in your own words, accessing your on-line

account. How did he do that? How did he dissuade you from doing

that?

Ms. STOUT. He really had not persuaded me not to. I was still

insistent on doing it, but when I called—he told me that he had

30

made up his mind when he went into business that he would never

have any on-line. He would not be harassed by his clients and I

said I have never harassed you, Frank. I would like to do it. It’s

a joy for me to learn new things and he said if you feel so strongly

I will have to get you another broker. And I thought, well, I don’t

know. And I kind of led him on and he said I’ll tell you what,

Golda, I’ve know you for all these years. I will send you the symbols and I thought all right. But I didn’t get the symbols. And then

I was going to call and say forget it.

Mr. TIBERI. Over the years you received monthly statements, Ms.

Stout?

Ms. STOUT. Yes.

Mr. TIBERI. I assumed you paid taxes on those statements?

Ms. STOUT. Oh, yes, I did.

Mr. TIBERI. How much tax do you believe you paid in the end on

money that you didn’t earn?

Ms. STOUT. Well, two years ago I almost went into hysterics. I

ended up paying $32,000 to the government. I paid quite a little

bit to the state, plus I had been paying quarterly for the estimated.

Now that will give you an idea of what I did do.

Mr. TIBERI. Ms. Stout, did either Cowen or Lehman offer to take

responsibility?

Ms. STOUT. No.

Mr. TIBERI. Okay. Has either company offered to make up the

losses incurred?

Ms. STOUT. No.

Mr. TIBERI. Mr. Fazio, has either company offered to make up

losses that you incurred?

Mr. FAZIO. No. They have not offered anything.

Mr. TIBERI. And neither Cowen or Lehman will take responsibility, Mr. Fazio?

Mr. FAZIO. No, they have not. I asked for some substance of some

kind until we settle it. They didn’t offer a dime, nothing.

Mr. TIBERI. Madam Chair, I’d like to yield the balance of my

time to Mr. LaTourette.

Mr. LATOURETTE. Thank you very much, Mr. Tiberi, for the courtesy on the little less than a minute that you have remaining.

Mr. Fazio, I wanted to reference before we go into other matters,

there was a rather obnoxious column in the Cleveland Plain Dealer

a couple of months ago and it’s unusual for the Cleveland Plain

Dealer, it’s a fine newspaper, but it suggested that those of you

who lost money were either sloppy, greedy or inattentive and that

perhaps participated in your own demise. And I would just like

you, sir, to indicate for the purposes of the record, were you a sloppy, inattentive or a greedy investor?

Mr. FAZIO. Absolutely not. I kept track of everything I did and

checked it against the statements and everything balanced. If it

didn’t, he would correct it. I was not a sloppy investor and this person, I was so mad when I read that article I wanted to cancel the

Plain Dealer.

Mr. LATOURETTE. The statements that you received from Mr.

Gruttadauria, did they mirror the notes and notations that you—

Mr. FAZIO. Yes, they mirrored my investments as I kept track in

several notebooks of my trades. They did. I want to add one other

31

thing, that in answer to another question, the customer did not

sign the form. When Lehman took over, I’m the client, it was

forged. My name was forged. Customers had no way of knowing

about the trades, the excessive trades or anything else. Signatures

were forged.

Mr. LATOURETTE. Thank you very much and thank you again,

Mr. Tiberi, for your courtesy.

Chairman KELLY. Thank you, Mr. LaTourette. Mr. Clay, have

you questions?

Mr. CLAY. Thank you, Madame Chair. Let me thank you for conducting this hearing as well as I’d like to ask unanimous consent

to submit my statement in the record.

Chairman KELLY. So moved.

Mr. CLAY. And yield the balance of my time to Ms. Jones.

Ms. JONES. Thank you, Mr. Clay. Ladies and gentlemen, I’ve

been able to twist all of my colleagues’ arms to tell them this is

my jurisdiction, give me your time and I thank each of them for

being willing to do so.

For the record, Madame Chairwoman, we had asked Mr. Samuel

Glazier to come and testify and under advice of his counsel, he

chose not to, but he is seated here in the room today and we do

have a letter from Mr. Glazier’s attorney that I’d like to submit for

the record, so that everybody will understand why it was he chose

not to testify.

[The following information was subsequently furnished by Hon.

Stephanie Tubbs Jones for the hearing record.]

Chairman KELLY. So moved.

Ms. JONES. Great. Thank you. Let me see, where did I leave off.

Let me go back to you, Ms. Richards. Tell us how you perceive

and Mr. Doherty, you can answer this question, that you, the Stock

Exchange, and you the SEC, are going to collaborate to see that

Mr. Glazier and Mr. Fazio and Ms. Stout and Mr. Stanton and others may be able to get some relief?

Ms. RICHARDS. Well, in our enforcement action that we filed

against Mr. Gruttadauria, we asked for disgorgement of any and

all ill-gotten gains. Any ill-gotten—

Ms. JONES. Just for the record, why don’t you tell us what

disgorgement is, okay?

Ms. RICHARDS. That’s a request to the Court that Mr.

Gruttadauria be ordered by the Court to turn over any monies or

property that he may have obtained unlawfully.

Ms. JONES. And so has he been enjoined from disposing of those

assets, have you corralled those assets for purposes of the possible

victims?

Ms. RICHARDS. We asked for, at the time we filed the complaint,

an asset freeze, a freeze of all of his accounts and the Court entered that order.

Ms. JONES. So who is it, if you can answer this question, responsible for corralling—you know, we generally set up someone who

has oversight over such assets. Has someone been assigned to do

that and are you able to tell us for the record what the value of

those assets may be at this time?

Ms. RICHARDS. As far as the value of the assets, I think it’s too

early to know. The Commission’s enforcement staff is still in the

32

midst of taking discovery and very actively investigating this matter, not only as to Mr. Gruttadauria, but also as to other individuals who may have assisted or participated in the fraud along with

him.

Ms. JONES. In light of the fact that Mr. Gruttadauria was employed by Lehman Brothers had you corralled any of Lehman’s assets in order to be able to satisfy the possible losses of these victims?

Ms. RICHARDS. Under the securities laws’ framework, there is a

remedy of arbitration. Each customer can arbitrate his or her dispute with a brokerage firm. In addition, I know that a number of

customers are considering taking action in Federal Court and State

Court.

Ms. JONES. Let me ask my question again, in light of the fact

that Mr. Gruttadauria was employed by Lehman Brothers, have

you corralled any of the assets of the Lehman Brothers or SG

Cowen in order to satisfy the losses of the victims of this particular

incident?

Ms. RICHARDS. The Commission doesn’t have authority to obtain

monies directly on behalf of investors. Typically, when we obtain

disgorgement of ill-gotten gains, we would then seek the Court’s

approval to disperse those moneys back to investors who were defrauded.

Ms. JONES. Isn’t it conceivable, Ms. Richards, that Mr.

Gruttadauria had ill-gotten gains, Lehman Brothers also had illgotten gains, so in fact, their assets ought to be corralled? Let me

cut if off. It’s conceivable that if Gruttadauria got ill-gotten gains,

so did Lehman Brothers, because it’s based on a commission. Is

that true?

Ms. RICHARDS. The Commission is continuing to investigate the

conduct by the two brokerage firms that employed him.

Ms. JONES. So you’re saying the SEC has no authority to deal

with Lehman Brothers as they’re dealing with Gruttadauria in

term of assets?

Ms. RICHARDS. The Commission has the authority to bring enforcement actions against both of those firms and we are very actively investigating them. Both of these firms are still in business.

Both of these firms are healthy. They have adequate net capital.

They have adequate reserves. This is not a situation—

Ms. JONES. How long does it take to declare bankruptcy, Ms.

Richards?

Ms. RICHARDS. I don’t know. These firms have adequate capital

to continue to do business.

Ms. JONES. I’m trying to get my staffer to find me a newspaper

article where Lehman is, in fact, claiming the possibility that so

many suits to cause them to be placed in financial difficulty. Have

you seen that article?

Ms. RICHARDS. I saw an article where they disclosed that the

firm was taking a reserve against the potential for lawsuits.

Ms. JONES. So what does that tell you?

Ms. RICHARDS. It tells me they’re starting to set aside money for

the possibility that they’ll have to make some of the victims whole.

33

Ms. JONES. So you’re saying to the world on behalf of the SEC

that Lehman Brothers is going to be in a position to settle or pay

up all these folks who have lost money. Help her out, come on.

Mr. DOHERTY. Could I add something? Since we’re investigating

this matter right now, I’d rather not comment on what we have in

mind here. But I can tell you that when we get involved in an investigation and we see customers who have been damaged and

have had money stolen, very much a high priority of our concern

before we resolve that enforcement action is that those customers

get taken care of and dealt with fairly by our member firms.

Ms. JONES. So are you saying that the stock exchange is going

to have the back of Lehman Brothers for satisfying the claims of

all these folks?

Mr. DOHERTY. What I’m saying is that since I can’t comment on

what we’re going to do in this case, I’ll tell you what we’ve always

done and what has been our consistent practice where investors

have had their money stolen by an employee of a member firm. We

have made it very clear to our member firms that we expect them

to deal fairly with their customers and reimburse their customers.

They understand that and I cannot think of a case in the last 10

years where an employee of one of our member firms has stolen

money and that that customer has not been taken care of by the

member firm.

Ms. JONES. Thank you, Madame Chairwoman. I appreciate the

time.

Chairman KELLY. Thank you. Ms. Richards and Mr. Doherty, I’d

like an answer to this question. Do either of your institutions have

any rules about the appropriateness of branch managers or brokers

who supervise their compliance officers? Do either of you have any

rule in existence now and did you back a couple of years ago? How

long has this rule been in place?

Ms. Richards, do you want to answer that first and then we’ll go

to Mr Doherty?

Ms. RICHARDS. Yes, as I said, broker-dealers have a duty to reasonably supervise. We would not consider a reasonable supervisory

system a structure in which supervision was had by a subordinate.

That to us would not reflect a reasonable system of supervision.

Supervision must be independent to be effective, so we would look

to someone outside of the branch manager’s chain of command to

supervise that branch manager’s activities.

I would note that that’s something that was specifically set forth

in my testimony as one of the practices that we intend to focus on

very hard in our examinations.

Mr. LATOURETTE. Will you yield to me just for that, on that

point?

Chairman KELLY. Of course.

Mr. LATOURETTE. In this situation where Mr. Semanek is the

compliance officer on behalf of Lehman Brothers and he’s a subordinate of Mr. Gruttadauria, are you indicating that that is a nonsatisfactory arrangement?

Ms. RICHARDS. I can’t comment on the facts of this particular

case because that very situation is under investigation by our enforcement staff, but a situation in which a subordinate of a branch

34

manager is supervising that branch manager’s activity, in my view,

doesn’t reflect a reasonable system of independence.

Mr. LATOURETTE. With the Chairwoman’s indulgence because I

don’t want to parse words or have anybody leave here and be confused, so you’re not going to comment about Mr. Semanek and Mr.

Gruttadauria, but if, for the purposes of a hypothetical there was

a guy in Cleveland who was the branch manager and his compliance officer was his subordinate, would you find that to be an inappropriate supervisory structure?

Ms. RICHARDS. In Cleveland or wherever—

Mr. LATOURETTE. Anywhere in the world.

Ms. RICHARDS. Yes, we would be very critical of that.

Mr. LATOURETTE. Thank you.

Mr. DOHERTY. Could I add that in our view a producing branch

office manager needs to be supervised with respect to his own production like any other salesman and so that I would completely

agree with Ms. Richards that supervision by a subordinate, if that’s

the sole aspect of the supervision, would not be, in our view, reasonable and we have brought enforcement cases against firms and

others where we felt that was a deficiency.

Chairman KELLY. Ms. Richards, it’s my understanding that you

put this oversight in place about 1998. Is that correct?

Ms. RICHARDS. Oversight?

Chairman KELLY. The oversight of the decision being that it was

inappropriate for a branch manager or a broker to supervise their

own compliance officer. Wasn’t that in place in 1998?

Ms. RICHARDS. The duty to supervise has certainly been in place

and is the framework, the linchpin of the federal securities laws—

Chairman KELLY. So it was not enough to stop Mr. Gruttadauria,

is that correct? Must have been. Is that correct?

Ms. RICHARDS. Existing duties to supervise apparently failed

with respect to Mr. Gruttadauria.

Chairman KELLY. Thank you very much. Does either the SEC or

the New York Stock Exchange believe that they require greater authority to detect fraud similar to Mr. Gruttadauria’s? Is there

something here that we need to look at at the federal level that

will not impinge on the trading that’s occurring, will not impinge

on the markets and yet do you need another tool in your toolbox?

Ms. RICHARDS. I would say that, on behalf of the Commission,

that we have 250 examiners for a population of 8,000 registered

broker dealers, some 90,000 branch offices and 678,000 registered

representatives that we police, with the SROs, with 250 examiners.

The Commission is now engaged in a top-to-bottom review of its resources to determine whether or not we need more—just simply

need more people to do the job that we need to do. Chairman Pitt

has spearheaded that effort and we’re working closely with him to

make those kinds of determinations.

Chairman KELLY. What about you, Mr. Doherty?

Mr. DOHERTY. My reaction is I don’t think we need additional authority. I think we need to continue to gather information and

adapt our program. We have under consideration some rules that

would impose more specific requirements in this area that would

hopefully go a long way toward enhancing investor protection in

this area.

35

In the final analysis, however, responsibility has to be on the

member firms to put in place the kind of procedures that the rules

require and run their business in a way that’s compliant with the

rules. We oversight that. The SEC oversights that.

Overall, this system, has given us the best markets in the world,

but that doesn’t mean that we can’t improve things and that’s what

we’re trying to do.

Chairman KELLY. Well, I thank you all for your testimony. I

want to note that some Members may have additional questions.

I’m sure they do have additional questions for this panel and they

may wish to submit them in writing. So without objection, the

hearing record will remain open, as I had stated earlier, for 30

days for Members to submit written questions to these witnesses

and to put their responses in the record.

I’d like to thank the first panel very much for appearing here.

We appreciate your testimony and I want to especially say to you,

Mr. Fazio, and Ms. Stout, you are excellent spokespeople for those

people who were damaged by Mr. Gruttadauria’s actions and we

thank you for traveling so far to be with us today.

With that, I’m going to excuse this first panel with our great appreciation. Thank you so much.

Ms. JONES. Madame Chairwoman, just for the record, I found

that newspaper article that I was talking about with Lehman

Brothers with the reserves and not having enough money to help

out these folks and I would just like to submit it for the record.

Chairman KELLY. With unanimous consent, so ordered.

Ms. JONES. Thank you.

Chairman KELLY. This panel is excused. I’d like to have the second panel start taking their seats.

For our second panel we welcome Mark Kaplan, Managing Director and General Counsel, SG Cowen Securities; Mr. Thomas

Hommel, Managing Director and Co-Head of Global Litigation for

Lehman Brothers; Daniel Sibears, did I pronounce that correct?

Mr. Sibears, did I pronounce that correctly?

Mr. SIBEARS. It’s pronounced Sibears.

Chairman KELLY. Sibears, thank you very much. Mr. Sibears,

Senior Vice President and Deputy for Member Regulation for the

National Association of Securities Dealers; Mr. Bradley Skolnik, Indiana Securities Commissioner and Chairman of the Enforcement

Section of the North American Securities Administrators Association; and Marc Lackritz, President of the Securities Industry Association. And we thank all of you for being here. I appreciate your

testimony before us today and I welcome you on behalf of the full

committee. Without objection, your full written statements and any

attachments that you have will be made part of the record and

you’ll each now be recognized for a 5-minute summary of your testimony.

I’d like to begin with you, Mr. Kaplan.

STATEMENT OF MARK E. KAPLAN, MANAGING DIRECTOR AND

GENERAL COUNSEL, SG COWEN SECURITIES

Mr. KAPLAN. Thank you. Madame Chair, Members of the Subcommittee, I thank you for the opportunity to come before this

Panel for this important hearing. On behalf of SG Cowen, I pledge

36

our company’s full support for your efforts. We applaud the Subcommittee for its leadership in working to protect investors from

fraud and other abuses.

SG Cowen is committed to doing everything possible to get to the

bottom of this scheme and to do what’s right for our former clients

by making every effort to reach a fair and equitable resolution of

their claims.

I want to begin by briefly reviewing SG Cowen’s short involvement in the retail brokerage business and where Frank

Gruttadauria fit into that business. In July 1998, SG Securities

purchased most of the assets of Cowen & Company, a wholly unrelated firm. Frank Gruttadauria had worked for Cowen & Company

for over eight years.

SG Securities did not have a retail brokerage business until this

acquisition. With the purchase, SG Cowen was formed as a fullservice investment banking and retail brokerage firm in the United

States.

In October 2000, a little over two years later, SG Cowen’s retail

brokerage business, including Frank Gruttadauria and his accounts, were sold to Lehman Brothers. Our firm has been out of

the retail brokerage business since that time.

Because we sold that business, we are faced with a unique and

significant challenge in piecing together what happened in the

Gruttadauria scheme. First, practically everyone involved in SG

Cowen’s retail brokerage business no longer works at the firm. As

a result, we lack the institutional memory that would help us resurrect and reconstruct what happened during the time that Mr.

Gruttadauria worked at the firm.

Second, the files that we are researching are stored on vast

amounts of paper and microfiche, not electronically. That requires

us to manually review more than 11,000 boxes of documents relating to hundreds of thousands of transactions and, to unravel this

scheme, we must analyze every transaction in every account.

Lastly, we are attempting to unravel a scheme that escaped detection, notwithstanding the due diligence, compliance procedures

and independent reviews of several distinct companies and outside

entities—which points to the sophistication and the complexity of

this scheme. Even so, speaking for SG Cowen, we wish our efforts

had uncovered it sooner and we’re doing everything we can to ferret out what really happened.

To do that, and from the very first day we learned of this problem, SG Cowen has dedicated substantial company resources to the

complex task of reconstructing client records. This includes well

over 100 people working on a nearly around-the-clock basis. We estimate that more than 30,000 person-hours have been expended in

this effort and we are far from finished.

While this is very much a work in progress, we have learned

some things that I would like to share with the panel. However,

and as I am sure you understand, we simply cannot comment on

matters that bear on the on-going investigations of the SEC and

the New York Stock Exchange and that are the subject of private

litigation.

What I can say is that some clients did receive false statements

with inflated account balances from Mr. Gruttadauria. When they

37

sought to withdraw funds, based on these artificially high levels,

Mr. Gruttadauria had to get the money from somewhere else and

that turned out to be the accounts of other clients. That appeared

to require him in turn to provide false statements to those other

clients and so the scheme grew. Thus, at its root, this was a

scheme in which Frank Gruttadauria appears to have been robbing

Peter to pay Paul. Many questions still remain. Did some people

lose substantial sums? Did some people wind up with substantially

more money than their investments would have earned? Were the

compliance procedures and supervision at the various firms inadequate? Or was Frank Gruttadauria’s scheme unusually sophisticated in evading detection?

Because of the nature of this scheme, we need to understand

what happened with all transactions and all affected accounts before we can determine how to address any individual client’s claim.

Again, we are pursuing this task with great urgency, but it will

take time.

Members of the Subcommittee, we offer our sincere apology to

the former clients of SG Cowen for the harm that Frank

Gruttadauria’s conduct has caused them. His conduct is anathema

to us. That is not the way we do business and that is not who we

are. We are proud of our hard-earned reputation for integrity in

the marketplace and for what we do for our clients. That is why

SG Cowen will continue to work tirelessly to determine exactly

what happened and to make every effort to reach a fair and equitable resolution of our former clients’ claims. We know that that

can’t happen fast enough for them and they are absolutely right.

With that, I thank you very much for the opportunity and welcome the chance to answer any questions you may have.

[The prepared statement of Mr. Mark Kaplan can be found on

page 96 in the appendix.]

Chairman KELLY. Thank you very much, Mr. Kaplan.

Mr. Hommel.

STATEMENT OF THOMAS E. HOMMEL MANAGING DIRECTOR

AND CO-HEAD OF GLOBAL LITIGATION, LEHMAN BROTHERS

Mr. HOMMEL. Thank you, Madame Chairwoman. My name is

Thomas Hommel. I’m a Managing Director with Lehman Brothers

in New York. I have a few remarks that I’d like to read into the

record, after which I’d be happy to answer any questions that the

Committee may have for me.

In January of this year, Frank Gruttadauria reportedly sent a

letter to the FBI admitting that he had defrauded his clients for

a period of 15 years. Mr. Gruttadauria worked for Lehman Brothers for only 15 months at the very end of this 15-year period. His

employment resulted solely from Lehman’s acquisition of certain

retail customer accounts and branch offices from SG Cowen &

Company in October of 2000. Prior to Lehman’s acquisition of the

Cowen branches, we performed due diligence with respect to

Cowen’s personnel and operations. Our due diligence disclosed that

Mr. Gruttadauria had a spotless compliance record with not even

a single customer complaint against him, nor were there any significant number of customer complaints in the entire Cleveland Office.

38

Lehman acquired over 60,000 accounts from Cowen, including

4,900 in the Cleveland Branch Office. Approximately 470 of those

accounts were handled by Frank Gruttadauria. It now appears that

Mr. Gruttadauria was indeed deceiving a relatively small number

of those clients, as well as his employers. He did so by diverting

account statements generated by the brokerage firms for which he

worked and preparing and sending to these clients false statements

reflecting nonexistent trades and false account balances. These activities took place for a 15-month period at Lehman Brothers for

two basic reasons. First, the addresses received by Lehman for 40

of Mr. Gruttadauria’s 470 accounts were incorrect. These were the

diverted statements. Second, the assets delivered over to Lehman

from Cowen in those accounts were relatively small and the account activity, both trading activity and transfers of funds, was virtually nonexistent outside of a handful of accounts. Since a brokerage firm is charged with safeguarding a client’s securities and

funds, compliance systems are designed to do just that and a lack

of activity in these accounts at Lehman meant that they were not

singled out for scrutiny.

At the cornerstone of supervisory procedures for every brokerdealer is the ability independently to send to all of its customers

confirmations and monthly statements reflecting all activity in

their accounts. In the tape to tape or computer transfer of account

information from Cowen to Lehman in October of 2000, the incorrect addresses that Mr. Gruttadauria had put in place at Cowen

were transferred to Lehman. Thus, a fundamental supervisory tool

had been taken away from Lehman without its knowledge as a result of purchasing accounts that had defective addresses.

Moreover, nothing about the addresses that were on these accounts appeared suspicious in any way. In virtually all instances,

the addresses appeared to be accounting firms or law firms which

presumably had been employed by the high net worth client, or

otherwise contained street addresses. Indeed, there is nothing extraordinary about a high net worth client directing his broker to

send account statements to his accountant or to a lawyer. One of

the accounting firms listed had a post office box included in the address, while another was, in fact, an actual accounting firm with

its actual street address listed. Thirty of the 40 accounts transferred from Cowen to Lehman that had incorrect addresses were

directed to one or the other of these accounting firms. The 40 accounts that were transferred to Lehman that had bad addresses

contained assets of less than $5 millon. The false account statements for those same accounts reflected equity of over $250 million.

From these hard facts, it is clear that to the extent that the assets

reflected in the false account statements ever existed, they had

been dissipated long before they reached Lehman Brothers. Because there were relatively modest amounts in the Lehman accounts, there was little or no trading in these accounts. There were

few transfers of funds as well, again, putting aside a small handful

of accounts.

On January 17, 2002, the very same day Lehman learned about

the alleged misappropriation, it sent a new management team to

Cleveland, as well as various other personnel to immediately meet

with clients. Lehman also immediately notified its regulators and

39

has fully cooperated with the numerous inquiries it has received

from those regulators and other governmental entities. The complete former management team of the office was replaced. All of

Mr. Gruttadauria’s clients were immediately contacted to ensure

that they knew precisely what was in their accounts and meetings

were conducted with the affected customers to fully share with

them what information the firm had regarding their accounts. Indeed, within 3 weeks of Mr. Gruttadauria’s disappearance, Lehman

Brothers had contacted substantially all of Mr. Gruttadauria’s 470

clients and we personally have met with representatives, either

family members or counsel, of 24 of the families involved in Mr.

Gruttadauria’s scheme, accounting for all but a few of the 60 accounts, which includes the fictitious accounts, for which false statements were prepared.

Moreover, Lehman has already paid substantial sums to certain

customers, including the customers whose accounts served as the

bank for Mr. Gruttadauria’s scheme at Lehman Brothers, to reimburse them for funds misappropriated from their accounts while at

Lehman, without requiring those people to sign releases. Lehman

believes that the amounts already paid represent a substantial portion of any funds that may have been misappropriated while Mr.

Gruttadauria was employed by Lehman, and is continuing its efforts to identify and reimburse any remaining customers for any

such misappropriation that may have occurred at Lehman. Lehman

Brothers, unfortunately, was in the unenviable position of having

to tell these customers that they were not worth what they thought

they were. However, substantially all of the alleged inflation in the

account value and substantially all of the alleged misappropriation

took place prior to these people ever become customers of Lehman

Brothers. Lehman Brothers, as part of its 150 year tradition, places

an enormous premium on earning the trust and confidence of its

clients. We regret deeply that these events took place, but also

firmly believe that our systems of supervisory procedures are more

than reasonably designed to prevent and/or detect this type of activity.

Indeed, Lehman’s compliance record since 1994, when the new

Lehman Brothers re-emerged, is an enviable one, with not a single

regulatory sanction associated with our private client services business. We will continue to work with the affected clients, with their

counsel, with the regulators and the Courts, to resolve the claims

that have been raised in the most fair and efficient manner possible.

Thank you.

[The prepared statement of Mr. Thomas E. Hommel can be found

on page 104 in the appendix.]

Chairman KELLY. We thank you.

We next go to Mr. Sibears.

STATEMENT OF DANIEL M. SIBEARS, SENIOR VICE PRESIDENT

AND DEPUTY FOR MEMBER REGULATION, NATIONAL ASSOCIATION OF SECURITIES DEALERS

Mr. SIBEARS. Chairman Kelly, Members of the Committee, thank

you for the opportunity to testify on behalf of the NASD. First, let

me briefly describe the NASD. The National Association of SecuriVerDate 11-MAY-2000 11:40 Oct 29, 2002 Jkt 000000 PO 00000 Frm 00043 Fmt 6633 Sfmt 6633 C:\DOCS\82396.TXT HBANK1 PsN: HBANK1
40

ties Dealers is the world’s largest self-regulatory organization or

SRO. Under federal law, the roughly 5500 brokerage firms and almost 700,000 registered representatives in the U.S. securities industry, comes under our jurisdiction. Employing industry expertise

and resources, we license industry participants, write rules to govern the conduct of brokerage firms, educate our members on legal

and ethical standards, examine them for compliance with NASD

and federal rules, investigate infractions and discipline those who

fail to comply. We have a staff of 2,000 with headquarters in Washington, D.C. and 15 district offices throughout the country. We are

governed by an independent Board of Governors, at least half of

whom are unaffiliated with the securities industry.

I’m the Senior Vice President and Deputy for the Member Regulation Department which has over 800 dedicated employees. My

testimony today will focus on the exam program which is the largest function carried out by member regulation. I recognize that the

Committee has a significant interest in the Gruttadauria case. For

the reasons set forth in my written statement, however, I am not

in the position to comment specifically on that matter which is

under investigation by the New York Stock Exchange and the Securities and Exchange Commission.

On an annual basis, the NASD examines approximately 2600

brokerage firms’ headquarters and over 200 branch offices. The

yearly schedule of exams is prepared in conjunction with other

SROs, including the New York Stock Exchange, pursuant to an

agreement to maximize cooperation and to minimize duplication

among regulators.

The exam process has advanced with technology. In the mid1990s, the NASD developed automated exam modules, essentially

taking the paper modules procedures and schedules of the past and

placing them on a computer. With the NASD’s recent development

of INSITE which stands for Integrated National Surveillance and

Information Technology Enhancements, we use sophisticated data

mining techniques to detect signals of change in member firm activities. This includes statistical analysis of customer complaints,

transactional and trading information, registration information and

financial information.

All this technology is helpful in identifying problems, but our

goal is to have the systems that encourage firms to identify and

stop problems before they happen. We use all the tools at our disposal, automated, manual and intellectual, to anticipate problems.

The tools used to conduct the exams have changed and although

the scope has grown, what we examine for has not changed radically. During our on-site visits to the firm’s office, the examiners

review the firm’s books and records such as financial computation

work papers and subsidiary ledgers, order tickets and confirmations, complaint and correspondence file and many other records.

Examiners check that the firm’s records support the regulatory filings that the firm has made to the NASD in the case of trade reporting, financial filings, complaint filings and advertising filings,

for instance. Examiners prepare independent financial calculations

to determine the financial condition of the firm, including such

measures as net capital and customer reserve. Examiners also

interview the firm’s compliance officers and management to learn

41

about its supervision in operational practices. The front line of our

system of preventive compliance is at the securities firm itself. All

securities firms are required to have supervisory systems and internal controls. NASD takes our members’ supervisory obligations

very seriously. Effective evolving supervisory systems form the

foundation of a firm’s ability to ensure that its associated persons

are appropriately dealing with customers and the customers are

protected. Appropriate supervision safeguards the firm and increases investor confidence, thereby ultimately ensuring the fair

and efficient functioning of our markets.

However, ordinary supervisory procedures may be insufficient to

ensure compliance in certain circumstances, circumstances that

may warrant heightened supervisory controls include registered

representatives who have been the subject of numerous customer

complaints, disciplinary actions or arbitrations, registered representatives terminated from association with prior firms for regulatory reasons or concerns, registered representatives who have frequently changed their employment and registered representatives

whose trading practices or customers appear on certain exception

reports generated by the firm to monitor customer accounts.

Firms that ignore such signals or red flags of sales practice violations or that never put in heightened supervision of problem brokers may themselves be the subjects of disciplinary action for failure to supervise the brokers. While today’s hearing is focused on

one bad actor, the overwhelming majority of NASD members materially comply with the letter and the spirit of the rules and the law.

They view their own reputation for fair dealing and high standards

as a competitive asset in a competitive industry.

The NASD’s job is to protect investors by setting high standards

of conduct and by disciplining those that fail to live up to those

standards, sometimes by barring them from the industry for life.

I’d be pleased to take any questions that you may have.

[The prepared statement of Mr. Daniel Sibears can be found on

page 109 in the appendix.]

Chairman KELLY. Next we go to Mr. Skolnik.

STATEMENT OF BRADLEY W. SKOLNIK, INDIANA SECURITIES

COMMISSIONER AND CHAIRMAN, ENFORCEMENT SECTION,

NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION

Mr. SKOLNIK. Chairwoman Kelly and Members of the Subcommittee, I’m Brad Skolnik, Indiana Securities Commissioner and

Chairman of the Enforcement Section of the North American Securities Administrators’ Association. I commend you for holding this

hearing and thank you for the opportunity to appear today.

The Securities Administrator in your state is responsible for the

licensing of investment professionals and securities offerings, investor education and most importantly the enforcement of state securities laws. We’ve been called the local cops on the beat and I believe

that is an accurate characterization.

Today, our focus is on the case of Frank Gruttadauria. My testimony will focus on two questions. What should be done to prevent

another Gruttadauria from cheating investors out of their money

42

and what steps can investors take to better protect themselves

from these criminals?

I believe our securities laws and regulations are fundamentally

sound. One lesson from this case might be that compliance departments need to toughen their enforcement of the rules already on

the books. Compliance departments must have reasonably designed

standards and systems in place to prevent and detect fraud. For example, it’s important that firms implement an effective, centralized

compliance system to approve the opening of accounts and to monitor associated name and address changes.

In addition, I encourage brokerage firms of a reasonable size to

provide on-line access to their customers’ account statements. Investors will then be able to check their mailed account statements

against the information provided directly by the firm’s website

which is not subject to manipulation by a crooked broker.

Another useful tool would be more resources for regulators. I applaud recent House action to raise the SEC budget. We need to

make sure that both state and federal regulators have the resources they need to do their jobs. There’s also another way to fight

these criminal fraudsters. Securities regulators must work with

prosecutors to obtain more criminal convictions. The prospect of serious jail time is the only way to deter these calculating cold-blooded recidivist criminals. Anything less is viewed as just the cost of

doing business.

Think about it. Someone steals your car, they go to prison. A con

artist steals the money your parents saved for retirement and all

too often, only gets fined. That’s just not right.

Make no mistake about it. Frank Gruttadauria stands accused of

being an unscrupulous scam artist and his alleged criminal activities will be addressed in a court of law. However, as a State Securities Commissioner, I’ve encountered too many fraudsters who have

swindled hard-working Americans out of their life savings.

Indeed, over the past few years, in my home state of Indiana,

we’ve encountered at least two high profile incidents where stock

brokers employed some of the same tactics such as the issuance of

fictitious account statements to plunder their clients.

The question is how can we better protect investors from being

victimized by the next Gruttadauria? We need to realize that no

matter what we do, there will be always be diabolical con artists.

That’s why stiff penalties and long prison sentences are so important.

In addition, NASAA has some tips for how investors might better

protect themselves from these sophisticated scams. First, periodically check mailed account statements against on-line information

from the firm’s website or by calling the firm’s headquarters. Secondly, we’ve all heard the saying, don’t put all your eggs in one

basket. Investors should consider spreading their investments possibly among two or three firms. Third, contact your State Securities

Regulator to check out a broker before doing business with them.

We can tell you if the company or individuals offering investment

advice are licensed or if they have any disciplinary history. Fourth,

use common sense. If written account statements show you’re making lots of money at a time when the stock market is in decline,

maybe you should double check your accounts with the firm’s comVerDate 11-MAY-2000 11:40 Oct 29, 2002 Jkt 000000 PO 00000 Frm 00046 Fmt 6633 Sfmt 6633 C:\DOCS\82396.TXT HBANK1 PsN: HBANK1
43

pliance office. Fifth, with the advent of desktop publishing and

technology, it’s not difficult to create bogus account statements. I

encourage investors to carefully check for typographical errors that

sometimes appear on falsified statements. Sixth, many investment

professionals use either custodians or clearing brokers to hold their

clients’ funds and securities. Investors should periodically compare

statements received from their broker with these independent third

parties for confirmation and accuracy. And finally, investors should

make sure their account statements are issued by the brokerage

firm or mutual fund complex and not from some other assumed

business name used by the investment professional.

I applaud you for holding these hearings in an effort to shed

light on the criminal abuses in the securities markets. The problems in this area are serious, but can be successfully addressed if

securities regulators and policy makers work together on solutions

and if investors are properly educated so they can protect themselves. Thank you very much.

[The prepared statement of Mr. Bradley Skolnik can be found on

page 116 in the appendix.]

Chairman KELLY. Thank you very much, Mr. Skolnik. I hope

that anyone who receives a transcript or has any indication of what

you’ve just said who is an investor will listen and act upon those

seven suggestions. Thank you for putting them into the record.

We go now to Mr. Lackritz.

STATEMENT OF MARC E. LACKRITZ, PRESIDENT, SECURITIES

INDUSTRY ASSOCIATION

Mr. LACKRITZ. Thank you, Madame Chairwoman, and Members

of the Subcommittee. Thank you very much for the opportunity to

testify today to describe the regulatory structure of the securities

industry which I know you’ve already heard a little bit about, the

efforts that we’re making to continually improve compliance and

prevent fraud, and a new investor education and information efforts underway to help empower investors and prevent this kind of

incident.

The securities industry is profoundly concerned whenever an investor loses money through fraud and we share your Subcommittee’s outrage over this particular incident. Indeed, we’re embarrassed that this type of fraud has even occurred because although

it happens only rarely, it simply should not occur at all. Our industry prides itself on our dedication to ensuring the highest ethical

standards among our professionals and our deep commitment to

earn the public’s trust and confidence that the markets operate

fairly with complete integrity. When that trust and confidence are

undermined in any way, our reputations are diminished and investors become more reluctant to provide the capital that companies

need to grow and flourish, employ more workers and provide financial returns that boost our nation’s prosperity. That’s why we have

no tolerance for those who have broken the law and we believe that

bad actors should be prosecuted to the full extent of the law.

Although this, episode of fraud is egregious and unacceptable, it

is important to note how rare these incidents are. More than 99.99

percent of all transactions result in no complaints, a record that

other industries and professions envy. Since 1995 the increases in

44

dollar volume in securities transactions dwarf the increase in complaints. Every single day nearly $700 billion in transactions clear

and settle on the stock and debt markets based on a handshake,

a nod, a hand signal, a keystroke or a phone call. This would not

be possible without strong, fair regulatory scheme that protects investors and ensures the integrity of the markets.

The securities industry multi-tiered regulatory structure makes

them amongst the most highly regulated industries. The first layer

of investor protection occurs within the brokerage firm itself.

Broker dealers are responsible for complying with every law and

regulation pertaining to their business, including the strict supervision of all personnel. They must also comply with mandatory continuing education programs.

SROs, the second tier of regulation, verify that brokerage firms

have systems and procedures in place to manage themselves properly and to comply with securities regulations, review firm’s books

and records, and administer tests and supervise the industry’s

mandatory continuing education requirements. They also create a

compliance system by which individuals and securities firms can

police their own activities. For example, the NASD regulation

maintains a public disclosure program on its website. I’ve give you

that address in my written testimony, as well as a toll-free telephone number that provides disciplinary information on all licensed securities brokers. This resource which we believe is unique

in any profession, enables investors to know instantly whether a

broker with whom they are considering doing business has ever

had disciplinary action taken against him or her.

As you know the SEC is charged with preserving the integrity,

efficiency and fairness of the securities markets by administering

and enforcing the federal securities laws. And it also oversees the

SROs. They have a long and successful history of detecting fraud

and punishing wrongdoers. This year already, the SEC brought

more enforcement actions in the first quarter, 61 cases, than it did

during the same period last year and in taking the helm of the

SEC, Chairman Harvey Pitt is refocusing the agency’s role on

catching problems early rather than spending years developing a

case and then imposing penalties. We support this effort and

Chairman Pitt’s request for more resources to expand the commission’s legal and enforcement staff and we appreciate this Subcommittee’s and Committee’s full support of greater resources for

the SEC because a fully-funded SEC is critical for both the securities industry and our customers.

As you know, Congress is the ultimate overseer and ensures that

the SEC is fulfilling its responsibility to regulate the markets.

This regulatory structure has been extremely successful by fostering the broadest, deepest, most transparent markets in the

world and now countries across the globe are trying to emulate our

system. I think we’ve established a record the entire industry can

be proud of, the public can rely on and other industries can only

envy. Yet, once in a while a bad actor slips through the structure

and defrauds our customers. When this happens, the industry

works very, very hard to make customers whole and to improve our

system by detecting and stopping fraud. Broker-dealers use sophisticated technology to detect abuses. For example, computers comVerDate 11-MAY-2000 11:40 Oct 29, 2002 Jkt 000000 PO 00000 Frm 00048 Fmt 6633 Sfmt 6633 C:\DOCS\82396.TXT HBANK1 PsN: HBANK1
45

pare clients’ electronically-stored profile against the trades he or

she is trying to undertake. If the two don’t match, the broker-dealers’ compliance officers will scrutinize the activity immediately.

Market regulators also use advanced state-of-the-art software and

computerized surveillance systems to detect and investigator signs

of foul play.

In addition to our efforts to stop fraud before it happens, the

broker-dealers in the industry are redoubling our investor education efforts so that investors will have the necessary tools and

skills to invest responsibly and avoid being defrauded. We have

published literally dozens of educational brochures and participated

in investor town meetings across the country organized by the

SEC. In addition, we fully support the Treasury Department’s new

campaign for financial literacy, a goal our industry has been committed to achieving for more than 25 years through our stock market gain. More than 600,000 students in fourth through twelfth

grade participate in this 10-week program that combines basic economic education with an investment simulation exercise.

We also recently launched a new website, www.siainvestor.org

which provides interactive on-line learning tools that addresses investors’ different needs and it’s free to anyone that accesses it.

The securities industry works in concernt with government, regulators and self-regulatory organizations to promote a culture of

trust and confidence which are our most important assets. In such

an environment, innovation soars, competition thrives and investor

confidence flourishes. We will continue to work together to eliminate any and all incidents of wrong-doing through effective leadership, compliance, self-regulation and more investor education.

These actions will help maintain and enhance the public’s trust

and confidence which is good for investors, good for our industry

and good for our country.

Thank you very much.

[The prepared statement of Mr. Marc Lackritz can be found on

page 122 in the appendix.]

Chairman KELLY. We thank you. I’d like to open the questioning

with a question to Mr. Kaplan and Mr. Hommel. Have you contacted Mr. Fazio and Ms. Stout with regard to their accounts because they said here, today that you have not?

Mr. KAPLAN. I can begin. I did hear their testimony. I have not

personally spoken to them. I have personally spoken to many of

Mr. Gruttadauria’s clients. The only thing that I can say, Chairperson Kelly, is that we are committed to reaching a resolution, a

fair resolution with each of these clients. It is very difficult, we understand, for these clients to have gone through this. We are committed to that process. We understand that it has been a long one,

but this is one that we are committed to and one we have devoted

a tremendous amount of resources to.

Chairman KELLY. Mr. Kaplan, if I understand the testimony

here this morning, Mr. Gruttadauria had less than 500 clients, is

that correct?

Mr. KAPLAN. I believe that may be generally accurate, correct.

Chairman KELLY. And Mr. Kaplan, all of this happened, the

problem became apparent as I understand it, in January. How long

46

do these people have to wait before they get some kind of contact

from your company?

Mr. KAPLAN. I agree with the Chairperson that this process has

not moved as quickly as we would like and I know the clients

would like. As I indicated in our oral statement, the process for us

of unraveling this scheme has been a very complex one and one

that has required a lot of time and a lot of resources.

As I indicated, this for us, has not just meant reviewing the two

years that he worked at SG Cowen, but we have gone back to look

at all of the records while he worked at Cowen and Company and

this has required us to piece together each of the individual transactions in each of the accounts which, because of the way records

were kept, has required a manual review of all of those records. We

have devoted at this time about $4 to $5 million to try to recreate

these accounts. This has meant scores of lawyers, scores of accountants. We recognize the urgency. We appreciate your efforts and you

have our pledge that we will work as quickly as possible to try and

reach a fair and equitable resolution with those clients.

Chairman KELLY. Mr. Hommel, you have not answered these

questions. Will you, please?

Mr. HOMMEL. Madame Chairwoman, within 30 days after Mr.

Gruttadauria’s disappearance, I personally met with Ms. Stout in

her home in Elgin, Illinois, as well as with Mr. Fazio and his counsel, Mr. Kranz, in Mr. Kranz’ office in Cleveland. We also met with

representatives or the clients of 24 of the other families who were

involved in Mr. Gruttadauria’s scam. The purpose of the meeting

was to make sure that these folks had the information that we had

so that we were all dealing with the same set of facts, and in fact,

many of the folks did not have their actual account statements. We

brought them with us and gave them to them. We asked them to

show us the false account statements that they were receiving so

that we knew what they were receiving and from that point forward, we’ve engaged them, in some instances with greater success

than in others, in discussions that are designed to ultimately lead

to a resolution of this situation.

Chairman KELLY. Mr. Kaplan, you’re aware, I know, of the New

York Stock Exchange 1998 enforcement action against Cowen. Can

you discuss with us the changes, if any, that the firm made to address the failure to reasonably supervise branch office managers

acting in the capacity of registered representatives, that that terminology was in that report. Can you address that?

Mr. KAPLAN. Yes. Shortly before SG Securities acquired Cowen

and Company, Cowen and Company did enter into a consent order

with the New York Stock Exchange that related to a number of different issues. As a result of that consent order, SG Cowen implemented a number of changes. It hired a number of additional personnel in the compliance department, including a new director of

branch examination whose role was to go out and conduct audits

of each of the branches. There was a compliance committee formed

at the very top of the company to review both the progress with

this order and to review generally the compliance procedures.

There were personnel changes in the margin department and there

were supervisory changes within the firm. I do know from looking

back at this material that six months later, an outside independent

47

law firm came and reviewed the changes that were made. That law

firm certified to the Exchange and certified to the executives at SG

Cowen that changes, in fact, were made. The issue that you raise

is an important one, which is whether those changes could have

prevented this fraud from happening. That is an issue that we are

looking at as well. That is an issue that we are cooperating on with

the New York Stock Exchange.

Chairman KELLY. Thank you. I’m out of time and I’m going to

go now to Ms. Jones.

Ms. JONES. Thank you, Chairwoman Kelly. Let me say at the

outset to all the panelists I have 5 minutes. I’m going to ask short

questions. I’d like short answers, if you could facilitate me, please.

Mr. Kaplan, during the period of time that Mr. Gruttadauria was

employed with SG Cowen, how much money did you make from his

trades?

Mr. KAPLAN. I am not sure.

Ms. JONES. Could you get an answer for me, sir?

Mr. KAPLAN. Yes, I will.

Ms. JONES. It was more than $2 million, $3 million, $4 or $5 million that you could say that, could you not, sir?

Mr. KAPLAN. I can’t speculate, but I will provide you with that

exact information.

Ms. JONES. How much money did SG Cowen make in 1995?

Mr. KAPLAN. We did not acquire Cowen and Company and Mr.

Gruttadauria until 1998.

Ms. JONES. How much did you make in 1998?

Mr. KAPLAN. Again, I apologize that I do not have those specific

figures.

Ms. JONES. You understand why I’m asking these questions, do

you not, Mr. Cowen

Mr. KAPLAN. You are right to focus on those issues. I apologize

that I don’t have the answers for you right now.

Ms. JONES. In fact, the people who lost dollars as a result of his

conduct—strike that. You do understand that you are responsible

for the conduct of Mr. Gruttadauria, do you not, sir?

Mr. KAPLAN. We understand our responsibility here.

Ms. JONES. That wasn’t my question. My question is that you do

understand that you are responsible for the conduct of

Gruttadauria?

Mr. KAPLAN. We do understand that and, as I indicated, we are

committed to reaching a fair and equitable resolution with his clients.

Ms. JONES. There may be a little question as to what is fair and

equitable in light of the fact that Mr. Gruttadauria represented to

these people and they relied upon his representation that they

have a certain amount of money when you may now come and say

well, the real thing you have was X, but I have a piece of paper

that said I had 10 times that?

Mr. KAPLAN. Well, I think that is one of the issues that will go

into the decision or the discussion as to what is a fair and equitable

resolution. There are clients—

Ms. JONES. Thank you very much. I hate to cut you off. Let me

go on now to Mr. Hommel. Pronounce it for me, sir?

Mr. HOMMEL. Hommel.

48

Ms. JONES. Hommel. How much did you make even though you

only had Mr. Gruttadauria, at least that’s your statement work for

you for only 18 months, how much money did you make from his

trading?

Mr. HOMMEL. I also do not have precise figures for you, but I

would note that the trading activity during Mr. Gruttadauria’s tenure at Lehman Brothers was very, very low.

Ms. JONES. That wasn’t the question I asked you.

Mr. HOMMEL. I don’t know, ma’am.

Ms. JONES. You can get that information for me, can you not, sir?

Mr. HOMMEL. I will.

[The following information was subsequently furnished by Mr.

Thomas E. Hommel for the hearing record.]

[During the period of time Mr. Gruttadauria was employed

by Lehman Brothers Inc. the gross revenue generated by

transactions in the accounts serviced by him was

$3,122,515. Mr. Gruttadauria’s total compensation for salary and sales credit for that same time frame was approximately $1,007,000.]

Ms. JONES. Can you tell me who Mr. Steve Lessing is?

Mr. HOMMEL. Mr. lessing is the head of sales for our organization.

[From 1996 through April 2000, Stephen M. Lessing was

Head of Global Sales and Research of Lehman Brothers

Inc., responsible for the Firms’s Fixed Income and Equity

Sales and Research organizations, as well as the Private

Client Services business. In April 2000, Mr. Lessing became the Senior client Relationship Manager for the Firm

and Head of the Private Client Services Group.]

[The following information was subsequently furnished by Mr.

Thomas E. Hommel for the hearing record.]

Ms. JONES. How long has he worked for Lehman Brothers?

Mr. HOMMEL. Mr. Lessing has been there for at least as long as

I have which is 16 years, but I don’t quite know the exact—

[Mr. Lessing has worked for Lehman Brothers for 22

years.]

Ms. JONES. Okay, and what was his supervisory authority, sir?

Mr. HOMMEL. He is basically the global head of sales.

[As head of Private Client Services, Mr. Lessing had general executive responsibility for the operation of that business, but was not the day-to-day business head.]

Ms. JONES. Then he had oversight over Mr. Gruttadauria?

Mr. HOMMEL. That would include institutional sales, retail sales,

sales in many different forms.

[From October 2000 to January 22, 2002, Mr.

Gruttadauria was employed in the Private Client Services

business of Lehman Brothers.]

Ms. JONES. The answer is yes or no, sir.

Mr. HOMMEL. Yes ma’am.

Ms. JONES. Okay, thank you. And what was he paid, sir?

Mr. HOMMEL. I don’t know, ma’am.

Ms. JONES. Can you get that information for me?

Mr. HOMMEL. I will do so.

49

[For the fiscal year 2001, Mr. Lessing was paid a salary

of $450,000 and received a cash bonus of $2,050,000. He

also received $2.5 million worth of restricted stock units

which will vest over a period of five years in accordance

with the terms of the plan pursuant to which they were

issued. Mr. Lessing also received options for the purchase

of 300,000 shares of Lehman Brothers Holdings Inc. stock.]

Ms. JONES. And you can also get for me the information as to

how much money you made as a result of the sales by Mr.

Gruttadauria.

Mr. HOMMEL. We will do that.

Ms. JONES. Let me go on a little bit. There’s an article dated

April 27th that says the SEC accuses Mr. Gruttadauria of stealing

client money for himself and using some of it to shower Ms.

English with $600,000 in cash and $100,000 worth of gifts. Let me

take you to the NASD standards for discipline and somewhere it’s

either there or one of your other people who testified said that is

a signal for a broker to not be giving gifts to other employees in

the firm. I’m not quite saying it correctly, but you understand what

I’m saying to you, don’t you, sir?

Mr. HOMMEL. Yes, we have a policy which prohibits managers

from making such gifts.

Ms. JONES. In fact, could you find out for me how much money

was showered upon Ms. English as a result of the conduct of Mr.

Gruttadauria and if, in fact, it was in violation of your standards,

what you did about it?

Mr. HOMMEL. We will endeavor to do that. Of course, we may not

have all the information necessary to get a complete picture. Ms.

English would be in a better position to do that.

[We are not in possession of any records or information regarding the value or extent of any gifts allegedly given by

Frank Gruttadauria to Laurie English. Lehman Brothers

was unaware of any such gifts.]

Ms. JONES. Let me ask you. What is a Lehman Brothers policy

with regard to a broker, a branch office manager supervising a

compliance officer and then who supervises a branch office manager? All right, who didn’t want me to talk? It’s okay. I’m going to

go anyway. Who supervises the branch office manager in his investment and trading?

Mr. HOMMEL. In this instance, Mr. Gruttadauria had a direct reporting line into the regional management office in Chicago, so he

was supervised directly by the regional manager in Chicago and

the regional office in Chicago.

Ms. JONES. And who was that person?

Mr. HOMMEL. The regional manager in Chicago’s name is Michael Smith.

Ms. JONES. Was he the regional manager at the time that Mr.

Gruttadauria was employed by your company?

Mr. HOMMEL. He was.

Ms. JONES. How much money did he make as a result of the

trading of Mr. Gruttadauria?

Mr. HOMMEL. I do not know.

Ms. JONES. You can get that information for me as well?

Mr. HOMMEL. I’d be happy to get that for you.

50

Ms. JONES. Thank you very much.

[There was no direct relationship between revenues generated by Frank Gruttadauria and Michael Smith’s compensation.]

Chairman KELLY. You’re out of time.

Ms. JONES. I’ll come back.

Chairman KELLY. Would you like to have those articles that you

held entered into the record?

Ms. JONES. Yes ma’am, thank you very much.

Chairman KELLY. With unanimous consent, so moved. Mr.

Tiberi.

Mr. TIBERI. Thank you, Madame Chair. To Mr. Kaplan and Mr.

Hommel, did Lehman and Cowen have a policy requiring disclosure

of a special fiduciary relationship and I’m speaking to the issue of

Mrs. Cuneo who passed away in 1997 and the fact that Mr.

Gruttadauria was named executor of her estate.

Mr. KAPLAN. On behalf of SG Cowen, I am not sure what the

firm’s policy was at that time as to individual brokers acting as

trustees for client accounts.

Mr. TIBERI. Can you get us that information?

Mr. KAPLAN. I can.

Mr. TIBERI. And can you get us that information of what—well,

it wouldn’t apply to you. Mr. Hommel?

Mr. HOMMEL. Yes. I can tell you that if a firm employee were to

accept responsibilities in that capacity, it would have to be disclosed. I will let you know whether or not there was a prohibition

on that, but I can tell you that if there were an acceptance of those

responsibilities it would have to be disclosed to the compliance department of the firm.

[S.G. Cowen approved of Mr. Gruttadauria acting as the

broker for the Estate of Anne Cuneo with respect to which

he acted as the Executor. Since that account was acquired

by Lehman, the relationship remained in place. At Lehman, the decision whether to allow a broker to service an

account where he or she may be acting in a fiduciary capacity is made on a case-by-case basis.]

Mr. TIBERI. Do you know, to your knowledge, did anyone check

those disclosures in Mr. Gruttadauria’s case?

Mr. HOMMEL. I don’t know.

[There is no record of any inquiry with respect to Mr.

Gruttadauria acting as Executor of the Estate of Anne

Cuneo.]

Mr. TIBERI. You can find out?

Mr. HOMMEL. We will find out for you.

Mr. TIBERI. Thank you. Continuing, Mr. Hommel, are the press

reports accurate that your firm gave Mr. Gruttadauria a $5 million

bonus to remain in the Cleveland office and run it?

Mr. HOMMEL. We paid Mr. Gruttadauria a $5 million retention

bonus as part of that acquisition, as we paid a retention bonus to

the other brokers of Cowen who came over to Lehman Brothers.

We believe that that is commonplace in these types of transactions.

I personally don’t know of any transaction involving the sale and

purchase of retail assets that did not involve retention bonuses for

the simple reason that ours is a very fluid industry from the emVerDate 11-MAY-2000 11:40 Oct 29, 2002 Jkt 000000 PO 00000 Frm 00054 Fmt 6633 Sfmt 6633 C:\DOCS\82396.TXT HBANK1 PsN: HBANK1
51

ployment perspective. Brokers are free to go to whomever they’d

like to work with.

Mr. TIBERI. Thank you. With that purchase, did you also accept

their liabilities and their assets?

Mr. HOMMEL. I’m sorry?

Mr. TIBERI. With that purchase, did you accept their liabilities

and their assets?

Mr. HOMMEL. No, we didn’t. We purchased accounts and the

asset purchase agreement is very clear that we did not accept liabilities.

Mr. TIBERI. During the purchase, were you aware of the 1998

fine against that office from the New York Stock Exchange?

Mr. HOMMEL. Yes, we were.

Mr. TIBERI. You were. And Mr. Kaplan, just to follow up on Ms.

Kelly’s question earlier, you said you had met with victims or met

with some of the victims. What efforts have been made by Cowen

to fully make the victims whole?

Mr. KAPLAN. At this point our efforts have been focused on trying

to understand what happened in each individual client’s accounts.

As I indicated in my oral testimony, this scheme was perpetrated

by shifting monies from one account to another account. In order

to understand what is a fair and equitable resolution with each client, we must understand how much a client put in and how much

a client took out. That process has involved a tremendous amount

of work and when we complete that process, we will meet with

each of the clients to reach that resolution.

Mr. TIBERI. What’s the time line, Mr. Kaplan, do you have any

idea?

Mr. KAPLAN. I hope to complete that process within the next several months.

Mr. TIBERI. I yield the balance of my time to Mr. LaTourette.

Mr. LATOURETTE. Thank you very much, Mr. Tiberi. Mr. Kaplan,

on October 15 of 1997, the New York Stock Exchange sat down

with counsel for Cowen, I believe they’re Wilke, Farr and Gallagher, and during the course of that and that had to do with the

allegation of violation of New York Stock Exchange Rule 342, failure to supervise in accordance with those procedures. And then in

the response document, do you have your response document from

that time with you?

Mr. KAPLAN. I do not have it, sir, although I have some familiarity with it.

Mr. LATOURETTE. Okay, and Madam Chairwoman, I’d ask unanimous consent that this response document be made part of the

record and I’d ask that the document be supplied to Mr. Kaplan so

that he can refer to it. But the salient points are that Cowen promised a sea of changes relative to the investigation by the New York

Stock Exchange and in pertinent part on page 76 indicates Cowen

recognizes the concern that arises from a situation in which the operations manager is placed in a position of supervising to even a

limited extent the individual to whom he or she reports. Does that

comport with your response to the New York Stock Exchange’s inquiry?

Mr. KAPLAN. Well, again, SG Cowen or SG Securities, when it

purchased Cowen and Company in 1998, was made aware of this

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consent order and, as I indicated, implemented a number of

changes in conjunction with the Exchange. In order to address

these very problems raised by the Exchange, it is clear that that

is one of the issues that we are looking into as to whether those

changes could have caught someone like Mr. Gruttadauria who perpetrated this scheme.

Mr. LATOURETTE. When Mr. Doherty met with me the other day, he indicated that the $385,000 fine levied by the New York Stock

Exchange, only 12 fines have been larger in the history of the Exchange. I don’t ask you to comment on that, but the question is if

the statements in that pleading were true, when SG Cowen acquired the business in 1998, it’s my understanding, even though

you couldn’t answer Ms. Tubbs-Jones’ question that Mr.

Gruttadauria generated for SG Cowen $5 million in 1998 and $5

million in 1999 as commission. Now I’ll ask you to go back and

check that out. And my question is, if that’s true, and I’m going to

ask you to assume that that’s true, how, by examining the accounts

that you took possession of in 1998, could there ever be a justification for fees or commissions of $5 million produced by this man?

The amount of equity in the accounts versus what the commissions

were, if you accept my statement that he earned $5 million for your

firm, they don’t match and why didn’t that do something to you

guys? Why didn’t that raise a red flag? Why didn’t that come to

anybody’s attention?

Mr. KAPLAN. Mr. Gruttadauria, as we have heard all of this

morning, put together a very complex and sophisticated scheme.

You heard how he gained the trust of his clients. He betrayed the

trust of these clients. One of the things that we’re looking into is

whether this was a matter of someone who put together a very

complex and sophisticated scheme that evaded detection by all of

the firms he worked for, firms that conducted due diligence, and by

their compliance departments and their supervisors. That is one of

the issues that we know we are obligated to address to this panel,

his former clients and to the Exchange. That is a very important

issue. I cannot at this point indicate how that took place.

Mr. LATOURETTE. Madam Chairwoman, I see Mr. Tiberi’s time

has expired. If I might continue on my own time?

Chairman KELLY. By all means, proceed.

Mr. LATOURETTE. Thank you very much. Mr. Hommel, that

raises a question of you and I’ll ask you to assume for the purposes

of my question that, in fact, Mr. Gruttadauria did earn commissions for SG Cowen of $5 million in 1998 and 1999, but regardless

of what the number is, during the course of the due diligence conducted by Lehman, you would be aware of what his potential was

or what he had generated for Cowen or no?

Mr. HOMMEL. We would know what his production statistics

were, yes.

Mr. LATOURETTE. For 1998 and 1999?

Mr. HOMMEL. Yes.

Mr. LATOURETTE. If I’m correct that for both years it was $5 million or there abouts and if you are correct that most of the thefts

that occurred prior to the transfer of these accounts from SG

Cowen to Lehman Brothers, does that not raise some question in

your mind how accounts that you say have a diminished value, by

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the time you receive them, have produced $5 million in commissions for SG Cowen in the two previous years?

Mr. HOMMEL. Certainly in retrospect, as we look at it now. As

we looked at it then, looking at the New York Stock Exchange investigation and the results of it and Mr. Gruttadauria’s statistics,

there was nothing to indicate to us at that point that whatever

commission level Mr. Gruttadauria earned in 1998 and 1999, was

through the use of anything but trading on a legitimate basis with

his accounts.

Mr. LATOURETTE. And Mr. Kaplan, back to you. We’ve heard talk

about the 1993 anonymous complaint filed with the Securities and

Exchange Commission and how that was resolved. Were you aware

of that, sir?

Mr. KAPLAN. No. As I indicated, SG Securities did not acquire

the firm until five years later. We first learned of this anonymous

complaint as it hit the press yesterday. We have checked our

records and we have seen no evidence of that in any of the due diligence or in his files.

Mr. LATOURETTE. And Mr. Hommel, the same question to you.

Before it was reported in the press, yesterday, did you have any

indication of this 1993 complaint?

Mr. HOMMEL. No, none whatsoever.

Mr. LATOURETTE. Mr. Kaplan talked about perhaps this was a

fellow who was engaged in a rather elaborate scheme, sort of indicating a uniqueness to it, but what Mr. Gruttadauria was up to

was not unique at all. This has happened before, has it not, this

same pattern of behavior, Mr. Hommel?

Mr. HOMMEL. I don’t see this as a pattern of behavior that we

have experienced before.

Mr. LATOURETTE. You do not see it?

Mr. HOMMEL. No, if you’re referring to—

Mr. LATOURETTE. Let me get to that. I think that Mr. Daouk and

when you were in my office, you indicated that Mr. Daouk is different because he was a referring broker, as opposed to someone

who is an employee and I guess that I became surprised then when

I read the District Court decision from 1998 that indicated that

Lehman effectively made WIS, Mr. Daouk’s company its de facto

branch office. And as I understand the facts in the Daouk case

which is currently—is it resolved yet?

Mr. HOMMEL. No, it’s still pending.

Mr. LATOURETTE. Then it was pending at the time that you were

doing your due diligence in an attempt to purchase SG Cowen’s retail business, was it not?

Mr. HOMMEL. It was.

Mr. LATOURETTE. It’s my understanding that in the Daouk matter, Mr. Daouk had created new signatures for clients to allow

them to authorize future transactions, that he had prepared and

distributed forged monthly account statements, that he had used a

personal off-network computer and that he had established post office boxes where he intercepted the client information sent from

Lehman and that he churned accounts in order to generate excess

commissions which were shared by both he and Lehman Brothers.

54

Is it your observation that that pattern of conduct that Mr.

Daouk is accused of engaging in is significantly different from Mr.

Gruttadauria’s behavior?

Mr. HOMMEL. I do.

Mr. LATOURETTE. And can you explain to me why you think that

is so?

Mr. HOMMEL. I think that because first, Mr. Daouk was never an

employee of Lehman Brothers. He was never an employee of

Shearson Lehman Brothers. He was an employee of E.F. Hutton

back in the mid-1980s in its Beirut office. E.F. Hutton closed its

Beirut office in 1986 and the office was taken over by a firm called

World Investor Services which never had any direct affiliation with

Shearson Lehman Brothers or Lehman Brothers. I think the passage you’re referring to is the court’s recitation of an allegation in

the complaint.

However, the fact is that World Investor Services entered into an

introducing broker relationship with E.F. Hutton to which

Shearson Lehman Brothers succeeded when Shearson bought Hutton in late 1987 or early 1988. That contractual relationship persisted through 1992 when the business left us. Mr. Daouk worked

for an introducing broker that referred accounts to E.F. Hutton and

later to Shearson Lehman Brothers. They were the primary point

of contact with those clients. The clients were predominantly Lebanese nationals with some Saudi nationals. The accounts were largely opened in the mid-1980s when there was a civil war in Lebanon.

Mail service was sporadic, if existent at all, and post office boxes

to my understanding, were in wide use. In any event, we never had

direct contact with these clients. Mr. Daouk, as the referring

broker, did. He also took discretion on the accounts so that

Shearson Lehman Brothers and Hutton before them, essentially

acted as a clearing broker for these trades.

Mr. LATOURETTE. The two accountant firms, accountancy firms

that Mr. Gruttadauria established, I’ll find my notes, but basically

where these statements were going, WJS and DH—

Mr. HOMMEL. One is an actual accounting firm.

Mr. LATOURETTE. Which one is an actual accounting firm?

Mr. HOMMEL. I believe it’s DeGrandis and DeGrandis.

Mr. LATOURETTE. Okay. And then how many of the fraudulent

statements were going to—the real statements were going to that

accounting firm.

Mr. HOMMEL. There’s a universe of 40 accounts that were transferred over. There were 60 accounts for which false accounts were

created, but a number of them had—they were fictitious in their

entirety, that is, there was no corresponding Lehman Brothers account. For the 40 accounts that came over from Cowen for which

fictitious account statements were created, but for which real accounts did exist, 30 of those account statements were diverted to

one or the other of the accounting firms. Seventeen, I believe, went

to JYM Accounting. JYM had a post office box. Those 17 were—17

of the 18 of the accounts that had post office boxes. The other one

happened to be a legitimate account so that the customer was actually getting the fake statement and the real statement with the

same number at the same address. However, 30 of the 40 went to

55

the accounting firms. Seventeen of them went to the post office

boxes in the name of JYM.

Mr. LATOURETTE. Were you in the room when the first panel testified?

Mr. HOMMEL. I was.

Mr. LATOURETTE. You had the opportunity to listen to those

folks. The exhibits that we put up relative to the activity, just

based upon your experience and how you guys run your firms, the

activity of Mr. Fazio’s account in 1990 that we had on the chart,

is there anything that in your experience would have triggered perhaps an inquiry by members of your firm had you been aware of

it?

Mr. HOMMEL. I think that those numbers may have triggered

some type of response from compliance supervisory systems, but to

say out of context right now what our reaction would have been

back then had it been us instead of some other firm, I don’t think

that I can speak to that.

Mr. LATOURETTE. How about you, Mr. Kaplan?

Mr. KAPLAN. I have the same response. Without knowing Mr.

Fazio and what his intentions are and investment philosophy, it is

hard for me to speculate as to what actions would have been taken

at the time.

Mr. LATOURETTE. Do you think, when we were talking to Ms.

Richards from the SEC, that perhaps it would at least cause you

to make an inquiry of the investor? Were they sort of this hyperactive investor that wanted to turn over their account 18 times in

six months?

Mr. KAPLAN. It is traditional in our industry that our compliance

officers, when they see an account with an unusual activity, that

they will make contacts with the client to ensure that that trading

is consistent with what they want.

Mr. LATOURETTE. How about you, Mr. Hommel?

Mr. HOMMEL. I would agree with Mr. Kaplan’s statement on that

point.

Mr. LATOURETTE. Thank you very much. Thank you, Madam

Chairman.

Chairman KELLY. Thank you very much. The questions here, I

know that they seem difficult, but on the other hand, they’re very,

very important to us in terms of understanding what has gone on

here and what our need is to respond to this.

I’d like to address a question to you, Mr. Sibears. Since we know

that the SEC had a clear indication of churning in 1993, and the

stock exchange performed some review of the Gruttadauria accounts in 1994 which might have caught him, I have to ask you,

did the NASD ever review specific customer account statements of

Gruttadauria clients?

Mr. SIBEARS. Chairman Kelly, we have gone back and done an

exhaustive review of the records of the exams that we’ve conducted

of firms that Mr. Gruttadauria was associated with and we’ve not

been able to detect any accounts that we have reviewed in the

course of examination program that were accounts of Mr.

Gruttadauria’s clients.

Chairman KELLY. Mr. Sibears, I find that a very interesting

statement since there was obviously some question here in 1993.

56

Again, 1998, there were some flags raised and yet there’s no record

of your looking back at what happened here, is that correct?

Mr. SIBEARS. Well, we certainly have a record of what examinations that we conducted that related to the firms in question, but

as Mr. Doherty testified to, the New York Stock Exchange has a

number of firms that are members of the New York Stock Exchange. I don’t believe, at least his oral testimony, mentioned the

fact that some of those firms, in fact, virtually all of those firms,

not everyone, are dual members of the New York Stock Exchange

and the NASD. And we have a very highly cooperative program between the New York Stock Exchange and the NASD that is designed to ensure that firms do not receive any kind of regulatory

overlap or unnecessary duplication.

So, for example, in a firm like these that we’ve been talking

about, when we did our reviews of Cowen and Lehman, our focus

tended to be not on financial issues or operational issues, but on

things that were unique to our jurisdiction such as municipal

underwritings, private securities transactions, trading of market

making rules that are unique to our authority as a regulator so as

to avoid the overlap. So in this kind of instance, it wouldn’t be particularly unusual.

Chairman KELLY. On page 5 of your testimony, sir, you go into

great detail about the number of scams that the NASD has found

that are carried out through the use of bogus post offices or bogus

addresses. You mentioned that you sent a member alert highlighting that concern to your member firms. Can you tell me when

you sent that member alert?

Mr. SIBEARS. Yes. We sent that on January 28th and what we

did was—

Chairman KELLY. January 28th of this year?

Mr. SIBEARS. 2002 and it was posted to our website which we—

is our standing operation procedure now, to get the broadest attention and audience.

Chairman KELLY. You also mentioned that you revised your examination procedures with this regard. Can you tell me when you

made those revisions?

Mr. SIBEARS. That was earlier in this year and the revisions that

we talk about in that testimony were directly related to the

Gruttadauria matter. We did have certainly a number of very extensive supervisory procedure examination steps, but those procedures in that exam protocol was refined as a result of this matter.

Chairman KELLY. All right, thank you very much. I have one

question for all of the witnesses and that is do you think that the

regulators need any new authority to enable them to specifically

detect this type of fraud, the type of fraud that was demonstrated

by Mr. Gruttadauria and I’m asking all of you.

Mr. Lackritz, why don’t we start with you?

Mr. LACKRITZ. Thank you, Madame Chairwoman. We would

strongly support increased resources for enforcement of the SEC as

I mentioned in my testimony. We strongly appreciated and supported your Committee’s action to increase the authorization of the

SEC, specifically for enforcement activity and I think that’s the

main area that we would recommend changing.

Chairman KELLY. Mr. Skolnik, have you a comment?

57

Mr. SKOLNIK. Madame Chairwoman, I believe that the securities

laws presently in place and the authority that state regulators, as

well as federal regulators and SROs have is adequate. I do concur,

I think that regulators at all levels probably need more resources

to deal with the demands that have been created by just the vast

increase in the number of investors who have entered our capital

markets in the last couple of decades.

Chairman KELLY. Mr. Sibears?

Mr. SIBEARS. With the caveat, Madame Chairman, that hopefully

we can supplement the record after we talk about this a little bit

more back at the NASD because I’ve been thinking of your question

since you asked Mr. Doherty and Ms. Richards. I think it’s an incredibly important question, but it strikes me that we have very

good and very broad authority and the important thing is the ability to both try to be very proactive and catch these problems

through our processes before they occur and have the flexibility to

very quickly amend our procedures and refocus our examination

and enforcement programs once something is brought to our attention which, for example, in this case, we were able to do. But I

would hope to be able to possibly even respond to this while the

record is open more fully.

Chairman KELLY. Mr. Hommel, Mr. Kaplan, would either one of

you like to respond?

Mr. HOMMEL. We believe that the current regulatory scheme is

adequate to protect the interest of investors. We firmly believe that

actually our compliance systems were the reason that Mr.

Gruttadauria’s scheme came to an end.

Chairman KELLY. Mr. Kaplan?

Mr. KAPLAN. I would agree that increased resources is critical for

the SEC and its audit function. However, these regulators cannot

be everywhere. They cannot look at every account and I think each

member firm, has an obligation to make sure that we maintain a

review of our clients, a review of our employees. That obligation is

on us as well.

Chairman KELLY. Thank you. Thank you very much. Ms. TubbsJones, do you have any more questions for this panel?

Ms. JONES. Lots. I only have 5 minutes. Mr. Hommel, did you

say that you believe it was your compliance system that brought

to light the conduct of Mr. Gruttadauria?

Mr. HOMMEL. We think that our compliance systems contributed

to the fact that he went underground when he did.

Ms. JONES. Now there’s a difference in contributing and bringing

to light. You do understand the distinction between the words?

Mr. HOMMEL. I didn’t mean to say anything other than that our

compliance systems contributed to the fact that he did.

Ms. JONES. I accept that change in your statement, sir. Did you

also say that you had an asset agreement that when the—the accounts transferred from SG Cowen or whatever the name of the

company—

Mr. HOMMEL. We purchased assets from SG Cowen. The assets

were the accounts.

Ms. JONES. And did you say that your agreement, in the agreement you did not accept any liabilities?

58

Mr. HOMMEL. No, the agreement we feel is quite clear that any

liabilities that arise from the operation of that business prior to the

closing date of the transaction remained with SG Cowen.

Ms. JONES. But any liabilities that result from any conduct after

the date of that transaction, you are responsible for?

Mr. HOMMEL. That’s correct.

Ms. JONES. Is that a fair statement?

Mr. HOMMEL. That is a fair statement.

Ms. JONES. Making that statement then, can you tell me when

you will respond to all these folks seated in the audience for that

liability?

Mr. HOMMEL. Well, we have responded to some of them, as I said

in my opening statement. We have reached interim resolutions

with some of the clients where we’ve identified misappropriated

funds. We have credited those clients. If I may, with respect to the

folks in here and many other folks, we’re in a difficult position in

that the assets that came over were pretty much static when they

hit Lehman Brothers. That is, there was no change in their actual

financial situation. That is a generalism, but largely true throughout the 40 accounts for which false statements were produced.

Ms. JONES. That’s your allegation. According to all these people

in the room the accounts have changed significantly since the time

they came from Cowen to Lehman.

Mr. HOMMEL. I don’t know that that’s what they say because

when they came in, the false account statements carried very large

balances which over time have not tremendously declined.

Ms. JONES. So you’re saying that most of the people in this room

were not damaged by the conduct of Mr. Gruttadauria?

Mr. HOMMEL. No, I’m not saying that at all.

Ms. JONES. I don’t want to press words with you. Let me move

on, okay?

Mr. Lackritz, in your statement, you say that there are three levels of regulation or supervision in your industry. The first level is

investor protection from the brokerage firm. The second is the selfregulatory organizations and the third is the Securities and Exchange Commission.

Mr. LACKRITZ. Yes.

Ms. JONES. If you were called as an expert witness in the lawsuit, all of these good folks against Lehman Brothers, what level

and I will ask you in your opinion, based on your background and

experience, sir, at what layer was there a breakdown? What layer

would that be, 1, 2 or 3? A breakdown in the supervision to avoid

what we have in place, the losses we have in place today, sir.

Mr. LACKRITZ. That’s a very tough question to answer, Congresswoman.

Ms. JONES. I know I ask tough questions. So give me a tough answer, sir.

Mr. LACKRITZ. I’ll do my best.

Ms. JONES. Okay.

Mr. LACKRITZ. I think that’s what the litigation and the enforcement actions are in the process of uncovering right now. There are

facts in each of these circumstances with respect to each of these

firms. Obviously, there was a breakdown in the system and obviously, this was an incident that—I’m embarrassed to be here. I’m

59

apologizing on behalf of the industry to the victims. In terms of—

it was a breakdown throughout the process.

Ms. JONES. So you would assess blame at every level of supervision? Or responsibility?

Mr. LACKRITZ. Yes, responsibility certainly.

Ms. JONES. So what would you do to improve, improve every

level?

Mr. LACKRITZ. I think that we have continually place emphasis

on improving compliance systems and technology in the firms

which we’re doing. We have to continue to increase investor education which we’re doing and improve compliance programs.

Ms. JONES. Thanks. I’ve got one last round of questions.

Mr. Skolnik, let me back up, real quick. Mr. Hommel, did you

say you didn’t learn until very recently about the 1993 case, sir?

Mr. HOMMEL. That’s correct.

Ms. JONES. And Mr. Kaplan, you said the same thing. Is that

correct?

Mr. KAPLAN. That is correct.

Ms. JONES. Then Mr. Skolnik, how could every day Joe and

Stephanie call the NASSA or their state security regulator to find

out about Frank Gruttadauria if neither of these companies who

specialize in hiring brokers knew about the 1993 conduct, sir?

Mr. SKOLNIK. Congresswoman, it’s very clear here that these investors were vigilant. As we heard today from the testimony that

I think touched us all, they did carefully scrutinize account statements and did ask, I think Mrs. Stout talked about how she challenged Mr. Gruttadauria and did ask questions.

One thing investors can do is to contact their state securities regulator to inquire whether the investment professional, the stock

broker or investment advisor they’re dealing with is properly licensed to be conducting business and to determine if they have any

disciplinary history.

In this case, unfortunately, it would not have necessarily have

detected any wrongdoing on behalf of Mr. Gruttadauria because he

did not have a disciplinary record. However, in a lot of cases, a lot

of enforcement cases and investigations that we initiate, we see situations where if investors had taken the opportunity to contact a

state securities regulator, they would have learned that the investment professional they are dealing with may have had a disciplinary record or worse yet, maybe was not even properly licensed to

conduct business.

Chairman KELLY. Thank you, Ms. Tubbs-Jones.

Ms. JONES. Thank you, Madame Chairwoman.

Chairman KELLY. Mr. LaTourette.

Mr. LATOURETTE. Thank you, Madame Chairwoman. I’d like to

throw this open to anyone on the panel because it’s a question that

comes up from time to time. Is there a recognized rule of thumb

for what the measure of damages should be in the situation that

we find ourselves in today?

Mr. Hommel?

Mr. HOMMEL. Given the pendency of litigation, I’m a bit restrained in what I can talk about. There are several theories of recovery that have been advanced by the plaintiffs.

60

Mr. LATOURETTE. I’m not interested in their theories. I guess I’m

wondering in cases that you’ve encountered during the course of

your career is there sort of a rule of thumb that this is what this

kind of theft is worth?

Mr. HOMMEL. I’ve not encountered a case specifically like this in

my career, but I would imagine that in approaching the situation,

what we try to do is define common ground with the complaining

customers’ rooted in the actual cash flows. That has been something that has prevented us from moving along in the negotiations

with some of these folks because, as I said, the cash flows at Lehman Brothers simply did not exist in many of these accounts.

Mr. LATOURETTE. Anyone else have an observation about how

these things are normally taken care of?

Mr. LACKRITZ. I think that in almost all of these situations, it’s

the responsibility of the firm to make their clients whole or to treat

their clients fairly and in almost all of these situations when they

occur and it’s very rare that they occur. I think it’s important and

I want to stress, the system actually works very effectively. Unfortunately, there are these rare instances when this kind of behavior

occurs and when it does, the firms take responsibility to treat their

customers fairly and make them whole in the circumstance.

Mr. LATOURETTE. And I think as I understood Mr. Hommel, we

can have different definitions of what making them whole means,

but is there any notion in this type of litigation relative to punitive

damages as opposed to negligence or not paying attention or when

someone actually goes out and steals, it’s under your supervision

as appears to be the case here, is there any notion of punitive damages in any of the cases that you’re aware of? If you know. If you

don’t that’s fine. I’m talking to you, Mr. Lackritz, I’m sorry.

Mr. LACKRITZ. I’m only aware of punitive damages in very rare

and unusual instances where there’s gross and willful negligence as

opposed to failure to supervise or something like that.

Mr. LATOURETTE. But in essence, if gross negligence gives you

punitive, I suppose intentional actions are even higher than gross

negligence and the other observation I would make is that Mr.

Hommel has never seen the situation, I guess, I would describe this

as unique, based upon the breadth of his experience.

Mr. Hommel, let me—you talked about due diligence when Lehman bought the business from SG Cowen. Can you describe in a

little detail for us what that means and specifically does due diligence include going into each and every one of Mr. Gruttadauria’s

accounts and physically looking at them or not?

Mr. HOMMEL. No, there would be no reason to go into Mr.

Gruttadauria’s accounts at that point. There were almost 100 brokers who came over with accounts that numbered in excess of

60,000, so it would require going into 60,000 accounts which is fairly impractical. What we did was we reviewed the compliance

records of every one of the brokers who were coming over and for

each broker who had one or more entries on his compliance record,

complaints on his compliance record, we gave them special scrutiny. We also did an analysis of the customer complaints throughout the Cowen system and we checked all the arbitrations and litigations that were pending against any of the registered representatives in the system.

61

We looked at the Cowen audits going back several years to see

what was turned up, all of which is, I would submit, somewhat

standard, but in this instance we also took a look at the New York

Stock Exchange report and the New York Stock Exchange report

had several issues that needed to be dealt with. As we look back,

it appeared that a prominent New York law firm had come in, had

assisted Cowen, in addressing those problems, had made recommendations that were subsequently adopted and as we looked at

that incident as a whole it appeared to us, not as a red flag, but

as an indication that Cowen had been inspected and corrected.

Mr. LATOURETTE. When you say that you looked at any complaints filed against the brokers that came over, we know today

that a complaint was filed against Mr. Gruttadauria in 1993. Are

you saying that the only complaints that you looked at were those

that resulted in a finding, some sort of adverse finding?

Mr. HOMMEL. No, we looked at complaints that were on the CRD,

the Central Registration Depository. There are certain requirements that a broker must report, complaints to the CRD, so we get

the broker’s registration file, which is the CRD file, and we see any

complaints that have been registered against that broker. For reasons that were explained before, apparently, this 1993 incident did

not make it on to Mr. Gruttadauria’s compliance record.

Mr. LATOURETTE. Okay. I thank you. I don’t think I have anything else.

Chairman KELLY. Thank you very much. The Chair notes that

some Members may have additional questions for this Panel and

they may wish to submit them in writing, so without objection the

hearing record is going to remain open for 30 days for Members to

submit written questions and for these witnesses to place their responses in the record.

The Chair also notes that Mr. Fazio and Ms. Stout have stayed

for this Panel’s testimony and let me say that I sincerely hope for

both of them that this hearing and that their testimony will result

in better protections for all investors. We appreciate the fact that

they came such a distance and took so much time and I think it’s

incumbent of all of the agencies that have been here, giving testimony today that they understand that this is not—it cannot be

business as it has been in the past. We must have better regulatory

oversight so this kind of thing and these kinds of people are never

again damaged. We must have a change. If you need this to come

from the federal government in the form of a law, then we will do

it. We need to do whatever we can to help the people of this nation

feel that they cannot lose their entire savings when they put their

savings in the trust of someone like Mr. Gruttadauria.

I will excuse the second Panel with our great appreciation for

your time. I want to briefly thank all of the Members and their

staffs, but also I want to thank my counsel, Mr. Andy Cochran, for

his terrific work on this panel and the other staff here on this Financial Services Committee. They’ve worked very hard on this

hearing and I thank them for their assistance in making the hearing possible.

This hearing is now adjourned.

[Whereupon, at 1:00 p.m., the hearing was concluded.]

(63)

A P P E N D I X

May 23, 2002

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