Court Opinion

ID: 808105
Source: CourtListenerOpinion
Date Created: 2012-09-07 18:43:33+00
Date Added: 2024-06-11T18:00:29.110397
License: Public Domain

United States Court of Appeals
                        For the First Circuit

No. 11-2247

                           RICHARD G. CODY,

                              Petitioner,

                                  v.

                  SECURITIES AND EXCHANGE COMMISSION,

                              Respondent.

                    PETITION FOR REVIEW OF AN ORDER
               OF THE SECURITIES AND EXCHANGE COMMISSION

                                Before

                     Boudin, Hawkins* and Thompson,

                            Circuit Judges.

     Stephen Z. Frank with whom Law Office of Stephen Z. Frank was
on brief for petitioner.
     Daniel Staroselsky, Senior Counsel, Securities and Exchange
Commission, with whom Mark D. Cahn, General Counsel, Michael A.
Conley, Deputy General Counsel, Jacob H. Stillman, Solicitor, and
Randall W. Quinn, Assistant General Counsel, were on brief for
respondent.

                           September 7, 2012

     *
         Of the Ninth Circuit, sitting by designation.
           BOUDIN, Circuit Judge.           Richard G. Cody seeks review in

this court of an administrative determination, sustained by the

Securities and Exchange Commission ("SEC"), that Cody mismanaged

various brokerage accounts under his supervision.                             The original

determination     including    sanctions          was    made       by    the    Financial

Industry   Regulatory       Authority      ("FINRA").           A    reasonably       full

description of the underlying events and evidence is required.

           In 1996 Cody became a "registered representative" in the

securities      industry,    that    is,      a   person       who       has    passed    an

examination     administered    by    FINRA       and     obtained        a     license   to

solicit, purchase, and sell securities while working with a member

firm of FINRA.        In practice, his clients often allow him to

exercise de facto control over their accounts, whereby he consults

the   clients    about   general     strategies          but    routinely         executes

specific trades on behalf of his clients without first asking for

their authorization.

           During his career he has worked for several different

brokerage houses including Merrill Lynch and Salomon Smith Barney

but between 2001 and 2005, he worked at Leerink Swann & Co.

("Leerink").     In 2003-2004, he made investments for two couples--

Richard and Lenore DeSimone and James and Emma Bates--certain of

which are the centerpiece of this case.                 These four were near or in

retirement, were not skilled investors, and expressed no interest

in acquiring speculative investments for the accounts at issue.

                                        -2-
           The DeSimones told Cody they desired investments that

would be relatively safe but that would provide steady income they

needed to fund their retirement. Lenore DeSimone had held a 401(k)

that carried mutual funds for about twenty years, and the DeSimones

had also held savings accounts, savings bonds, and a small account

previously managed by another broker.               At issue are two of the

DeSimones' several accounts: Lenore DeSimone's IRA and a joint

account.     For both the IRA and the joint account, the DeSimones

listed an investment objective of "long-term growth."

           The    DeSimones   asked     Cody   to     pursue   a   strategy   of

investing in safe, highly-rated bonds with maturity dates of around

ten years.    They told Cody they were relying on his expertise to

execute    this   strategy    in   a    way    that    would   protect   their

investments. On Cody's records, the IRA listed a risk tolerance of

"moderate" while the joint account listed a risk tolerance of

"speculation," but Lenore DeSimone testified that she believed that

Cody filled out the risk tolerance entry, and Cody conceded that

the DeSimones were not interested in speculation.

           James and Emma Bates were friends of the DeSimones, who

introduced them to Cody, and in February 2003, James Bates opened

an IRA with Cody.     James Bates' IRA initially contained assets of

$380,046; James Bates hoped that the account would generate a

monthly income of $2,000, which equated to an annual return of

approximately 6.3 percent.         In his account opening forms, James

                                       -3-
Bates listed    an   investment   objective   of    "income"   and   a   risk

tolerance of "low." Cody advised James Bates that he could achieve

the desired income while maintaining low risk by investing in

bonds.

            In February 2003, Cody invested money from James Bates'

IRA and the DeSimones' joint account in the Credit Suisse First

Boston Mortgage      Securities   Corp.   IndyMac   Manufactured     Housing

Passthru (the "Credit Suisse Security"), a fixed-income security.

Cody invested $86,500 from James Bates' IRA (23 percent of the

total account) and $31,725 from the DeSimones' joint account (13

percent of the total account) in the security.         The Credit Suisse

Security was collateralized by installment sales contracts and

installment loans for mobile homes.

            The Credit Suisse Security was one of eleven "tranches"

of securities collateralized by the same set of assets; its tranche

was eighth out of the eleven in order of priority.        This meant that

the security was eighth in line to receive payments, and fourth out

of the eleven to bear losses if the borrowers defaulted on their

payments.    The security carried a 7.105 percent coupon and had a

stated maturity of February 2028, but the borrowers had the option

of prepaying the underlying installment loans and contracts.

            Cody invested his clients' funds in the Credit Suisse

Security after it was recommended by a colleague at Leerink,

Timothy Skelly, who specialized in fixed-income securities. Skelly

                                    -4-
gave   Cody   basic   information--e.g.,   the   issuer,    the   coupon

percentage, the date of maturity, the nature of the collateral and

the chance for prepayment--and gave him a printout from Bloomberg,

but Cody did not seek out further information.

          Cody knew that the security had an A rating, but did not

know that it had been downgraded from AA by Fitch in October 2002.

When asked whether he "really understood" the security at the time

of the investments, Cody admitted, "At the time I sold it to them

I didn't really look at a CMO [collateralized mortgage obligation]

to be significantly different than any other bond; obviously, I've

learned quite a bit since then."   Cody bought the security the day

after Skelly first mentioned them.

          Over the next year, the Credit Suisse Security was

downgraded several more times, with the Fitch rating declining to

CCC in February 2004.     The market price of the security dropped

from $104 in February 2003 to $41 by February 2004.        Over the next

three months, Cody sold the DeSimones' investment at a loss of

$17,377 (55 percent of their initial investment) and James Bates'

investment at a loss of $56,868 (66 percent of his investment).

          In 2003, Cody invested James Bates' money in three non-

investment grade bonds.     A bond with a rating of BBB- or higher

from Standard and Poor's or Fitch or Baa3 or higher from Moody's is

considered investment grade.     Non-investment grade bonds, often

referred to as "junk" bonds, have a rating of BB+ or lower from

                                 -5-
Standard and Poor's or Fitch or Ba1 or lower from Moody's, and are

considered to be speculative, with a higher degree of credit risk.

Fabozzi, Bond Markets, Analysis, and Strategies 162-63 (6th ed.

2007).

          These investments were made in May 2003, when Cody

purchased Ahold Financial USA Inc. bonds, and in June, when he

purchased Calpine Corp. and Royal Caribbean Cruises, Ltd. bonds.

The Ahold and Calpine bonds were rated B1 by Moody's, and the Royal

Caribbean bonds were rated Ba2 by Moody's.       These bonds totaled

about 23 percent of the market value of James Bates' IRA.      Between

July and November 2003, Cody sold all of the bonds, realizing a

small gain on the investment, but the ratings were nevertheless for

speculative grade bonds.

          Cody engaged in frequent trading in 2003 and 2004 in

James Bates' and Lenore DeSimone's IRAs.    Cody made 140 trades (84

purchases and 56 sales) in Lenore DeSimone's IRA from June 2003

through May 2004.   He engaged in a pattern of in-and-out trading,

purchasing   several   securities   and   then   selling   those   same

securities just weeks later.   The purchases totaled more than $1.3

million, while the average value of the account was just $421,000.

          The trades generated over $36,000 in commissions to

Leerink, with Cody personally getting over $14,000 in commissions.

During that period, the account had a turnover ratio (annual

purchases over average account value) of 3.4 and a commission to

                                -6-
equity ratio of 8.7 percent, meaning that the investments in the

account would need to earn approximately 8.7 percent in annual

returns just to break even after commissions.

           In   James    Bates'   account,    Cody    made   108    trades   (69

purchases and 39 sales) from February 2003 through May 2004.

Although there was not sufficiently precise information available

to calculate turnover or commission ratios for this account, Cody

made purchases of approximately $1.7 million during the 16-month

period, when the total value of the account at the end of the month

was always less than $475,000.

           In addition, Cody employed a strategy of in-and-out

trading and generated over $41,000 in commissions for Leerink, of

which over $17,000 went to Cody.             Around May 2004, Emma Bates

questioned Cody about the trading in James Bates' account, and the

level of   trading      in both   James   Bates'     and   Lenore   DeSimone's

accounts subsequently declined.

           Cody also seemingly misled his clients in a number of his

monthly reports by reporting bonds at par value, without a clear

indication that this was so even when their market value was well

below that figure, significantly overstating the value of their

portfolios. After Cody left Leerink, Cody settled with the Bateses

and DeSimones, agreeing to compensate the DeSimones $20,000 and the

Bateses $56,000 for their losses on the Credit Suisse Security, but

                                    -7-
he delayed the required reporting of this information to FINRA for

over two years.

          On January 11, 2008, the Department of Enforcement of

FINRA filed a complaint against Cody.    FINRA is a self-regulatory

organization (SRO) that regulates professionals and firms in the

securities industry, inheriting the responsibilities of two earlier

similar bodies.    Under the Securities Exchange Act, SROs such as

FINRA can discipline members with penalties including expulsion,

suspensions, and fines but must provide a hearing and written

opinion and allow an administrative appeal.       Loss, Seligman &

Paredes, 6 Securities Regulation 199-200.

          The complaint alleged violations of NASD Rule 2310 and

NASD Rule 2110.1   Rule 2310 requires:

          In recommending to a customer the purchase,
          sale or exchange of any security, a member
          shall have reasonable grounds for believing
          that the recommendation is suitable for such
          customer upon the basis of the facts, if any,
          disclosed by such customer as to his other
          security holdings and as to his financial
          situation and needs.

Rule 2110 requires representatives to "observe high standards of

commercial honor and just and equitable principles of trade."

          After a lengthy period of discovery, a three-member FINRA

Hearing Panel conducted a five-day hearing from October 27, 2008,

     1
      Because Cody's disputed conduct took place before FINRA
amalgamated the functions of the National Association of Securities
Dealers ("NASD") and the regulatory arm of the New York Stock
Exchange ("NYSE"), the NASD pre-merger conduct rules applied.

                                -8-
through October 31, 2008.         At the hearing, Cody was represented by

counsel, both sides presented documentary evidence, both sides

called witnesses and cross-examined the other side's witnesses, and

Cody himself testified.          The panel issued a written decision on

January 29, 2009; the panel (unanimously) found

           -that in violation of Rule 2310 and Rule 2110
           Cody engaged in excessive trading of Lenore
           DeSimone's and James Bates' IRA accounts by
           conducting in-and-out trading for risk averse
           investors in a way that generated substantial
           commissions for Cody and Leerink;

           -that   (again    citing   both   rules)   the
           investments in the Credit Suisse Security were
           unsuitable because Cody did not understand the
           risks involved in the security [Add. 12-13],
           and the purchase of non-investment grade bonds
           for James Bates was unsuitable given James
           Bates' low risk tolerance; and

           -that in violation of Rule 2110 Cody's monthly
           statements were misleading and he improperly
           delayed   the   required  reporting   of   his
           settlements with his clients.

           The Hearing Panel imposed a fine of $20,000 and a three-

month   suspension   for    the    unsuitable        purchases   and    in-and-out

trading (one panel member urged six months), a $5,000 fine for the

misleading statements, and a $2,500 fine for the delayed reporting,

producing a total fine of $27,500 (along with costs of $7,087.50)

and a three-month suspension.            Both sides appealed and the Appeals

Panel   upheld   liability       (save    on   one    unimportant   detail)      and

affirmed all     fines,    and    increased     the    suspension      to   a   year,

                                         -9-
concluding that a "stronger sanction is needed to remedy Cody's

violations."

           Cody petitioned the SEC to overturn the FINRA findings

and penalties, save for the ruling about the monthly statements and

delayed reporting of settlements, and the associated $7,500 in

fines.    The SEC, reviewing the record de novo and considering

briefs from both sides, affirmed the liability findings on a

preponderance of the evidence standard and affirmed the appellate

body's   sanctions,   finding   that   they   were   not   unnecessary   or

inappropriate or excessive or oppressive, the standard required for

reversal of sanctions.    15 U.S.C. § 78s(e)(2) (2006).

           In this court, we review the order of the SEC rather than

FINRA's decisions.    See 15 U.S.C. § 78y(a)(1); Krull v. SEC, 248

F.3d 907, 911 (9th Cir. 2001).     The SEC's factual findings control

if supported by substantial evidence, 15 U.S.C. § 78y(a)(4); A.J.

White & Co. v. SEC, 556 F.2d 619, 621 (1st Cir.), cert. denied 434

U.S. 969 (1977), and its orders and conclusions must not be

"arbitrary, capricious, an abuse of discretion, or otherwise not in

accordance with law."    5 U.S.C. § 706(2)(A) (2006).

           Cody challenges the SEC's action on a number of grounds

but, in the end, none is substantial.         He begins by arguing that

FINRA itself is a "state actor" endowed with governmental powers

and is therefore required to provide due process under the Fifth

Amendment.   Two circuits have said no, others have expressed doubt

                                  -10-
and one has dicta referring to due process as governing NASD

rules.2    There may be other such cases.              This circuit has not

addressed the issue, and it would be pointless to do so here.

            By statute, FINRA was required to give Cody the substance

of procedural due process.       Gold v. SEC, 48 F.3d 987, 991 (7th Cir.

1995).     In addition to providing "fair procedure," an SRO must

"bring specific charges, notify such member or person of, and give

him an opportunity to defend against, such charges, and keep a

record."    15 U.S.C. § 78o-3(b)(8), (h)(1).          FINRA did so here; and

Cody nowhere explains just what would have been different if the

administrative     process for        collecting   evidence,   compiling the

record, evaluating Cody's conduct and imposing a sanction had been

done in the first instance by the SEC itself.

            The closest Cody comes is to argue that the Hearing Panel

erred in refusing his request to offer expert testimony.                      The

panel, like a court, had "broad discretion," Dep't of Enforcement

v. Strong, No. E8A2003091501, 2008 FINRA Discip. LEXIS 19, at *17

(FINRA    NAC   Aug.   13,   2008),    to   exclude   all   evidence   that   is

"irrelevant,      immaterial,         unduly    repetitious,      or    unduly

     2
      Compare Desiderio v. Nat'l Ass'n of Sec. Dealers, Inc., 191
F.3d 198, 206 (2d Cir. 1999), cert. denied 531 U.S. 1069 (2001)
(rejecting the state actor claim), and Epstein v. SEC, 416 Fed.
Appx. 142, 148 (3d Cir. 2010) (unpublished opinion)(same), with
Jones v. SEC, 115 F.3d 1173, 1183 (4th Cir. 1997), cert. denied 523
U.S. 1072 (1998), and Gold v. SEC, 48 F.3d 987, 991 (7th Cir.
1995)(expressing doubts), with Rooms v. SEC, 444 F.3d 1208, 1214
(10th Cir. 2006)(dicta that due process requires that a NASD rule
give fair warning).

                                       -11-
prejudicial."       NASD Rule 9263(a).           Cody sought to offer the

testimony     of   Gerald    A.    Guild   as   an   expert    in     fixed-income

securities, but the Hearing Panel said it "would not be necessary

or helpful to the Panel."          A similar offer to the Appeals Panel was

similarly rejected.

              A panel comprised of those experienced in the industry

was obviously less in need of expert advice than an ordinary judge

or jury.      But even in court a lawyer seeking to present expert

testimony will, if doubts are expressed, need to tell the judge the

substance of the proposed testimony and why it is needed.                    At the

FINRA proceeding, Cody failed to do so; indeed, even today Cody

does not tell us just what his expert was proposing to say.

Without it, FINRA had no reason to conclude that the evidence was

valuable, and nor do we.

              Cody's next objection relates to the multiple roles

played   by    attorney     Michael   Garawski,      FINRA   Associate      General

Counsel, who served as the Appeals Panel's counsel during Cody's

administrative     appeal,     a    role   in   which   he    ruled    on   various

procedural motions by the parties. After Cody appealed the Appeals

Panel's decision to the SEC, Garawski represented FINRA before the

SEC, and was the attorney who signed FINRA's brief.                 Cody contends

that Garawski's "dual role as adjudicator and advocate biased the

outcome of the administrative proceedings."

                                       -12-
              The objection is not on its face a promising one.

Government agencies, including the SEC itself, initially play the

role of adjudicator when they resolve complaints and then in turn

advocate when defending their resolution in court. This is not the

same thing as taking sides as an advocate in a proceeding and then

purporting to adjudicate the disposition or the appeal from it.

But something might turn on the circumstances and we have no

occasion to explore the matter here because the objection has been

forfeited.

              Garawski openly assumed the dual role; Garawski's role at

the   FINRA     Appeals   Panel   was   known   to   Cody    before   FINRA's

proceedings were over, and his role as an advocate before the SEC

was known before the SEC proceedings were over.             To preserve this

issue for review, Cody had to raise it before the SEC and failed to

do so.   By statute, "[n]o objection to the order of the [SEC] shall

be considered by the court unless such objection shall have been

urged before the Commission or unless there were reasonable grounds

for failure to do so."       15 U.S.C. § 80b-13(a).         See Armstrong v.

SEC, No. 09-1260, 2012 WL 1448980, at *2 (D.C. Cir. Apr. 25, 2012)

(per curiam); Dyer v. SEC, 290 F.2d 534, 539 (8th Cir. 1961).           That

ends the matter.

              Turning from procedural claims of error to substance,

Cody argues that his choice of the Credit Suisse Security did not

violate the suitability rule.           Remarkably, he argues that an

                                    -13-
investment recommendation is unsuitable only if the investment "on

its face, is unsuitable for any investor."      Appellant's Br. 37

(emphasis added).   Cody's interpretation conflicts both with the

rule's text and with any realistic policy designed to protect

investors according to their circumstances.

          The suitability rule requires reasonable grounds for the

recommender to believe that "the recommendation is suitable for

such customer upon the basis of the facts, if any, disclosed by

such customer as to his other security holdings and as to his

financial situation and needs."    NASD Rule 2310 (emphasis added);

see also F. J. Kaufman & Co. of Va., 50 S.E.C. 164, 168 (1989)

(requiring "a customer-specific determination of suitability").

And it is common sense that an investment that is suitable for some

investors may be unsuitable for other investors with completely

different investment objectives.

          Cody also objects that, contrary to the findings of FINRA

and the SEC, he had a sufficient understanding of the security to

recommend it.   The fact that he recommended a risky security to

customers who made clear their preference for safety strongly

supports the opposite conclusion, and anyway Cody admitted at the

FINRA hearing, "At the time I sold it to them I didn't really look

at a CMO [collateralized mortgage obligation] to be significantly

different than any other bond; obviously, I've learned quite a bit

since then."

                               -14-
               In particular, Cody did not know that the security's

credit rating had been recently downgraded, he did not know that

the security          was     one of       the    riskiest       tranches   of securities

collateralized           by   the    same    pool       of   assets,      and   by   his   own

admission, he did not understand that securities collateralized by

housing assets have fundamentally different risks than traditional

bonds       that   are      backed    by    the     credit       of   a   government   or    a

corporation.        Nor does Skelly's recommendation immunize Cody.                        The

responsibility to investigate belonged to Cody and the findings

against him are plainly supported.

               Finally, with regard to the Credit Suisse Security, Cody

claims that he was misled or the Appeals Panel erred because in the

hearing the security was often referred to as a collateralized

mortgage obligation (CMO), while the Appeals Panel called the

security an asset-backed security (ABS).                         But Cody had meaningful

and adequate notice, and at no point was confused as to which

securities were at issue.

               ABSs      are in      some locutions          a    general class       of   all

securities collateralized by financial assets while in the case of

CMOs the assets happen to be mortgages.3                         Quite likely, the loans

        3
      CMOs are defined as a class of ABSs by the Securities
Exchange Act. See 15 U.S.C.A. § 78c(a)(79) (West 2012) ("The term
'asset-backed security'-- (A) means a fixed-income or other
security collateralized by any type of self-liquidating financial
asset . . . including--(I) a collateralized mortgage obligation .
. . .").

                                                 -15-
and sales contracts in the Credit Suisse Security were secured by

some kind of property interest in the mobile homes that could

loosely be described as a chattel mortgage.   Indeed, he testified

that when he first learned of it Skelly informed him that the

Credit Suisse Security "was an asset-backed security supported by

mortgages on homes."

          Even if the Credit Suisse Security arguably might be

called something other than a CMO, on the theory that it was

collateralized by assets other than mortgages, the FINRA complaint

was sufficiently detailed to inform Cody that he was being charged

with unsuitable recommendations of the Credit Suisse Security,

regardless of whether it was better labeled a CMO or a non-CMO ABS.

Cody, like everyone else involved, knew beyond any doubt what

particular security was at issue and understood it was a security

collateralized by housing installment loans and sales contracts.

          Finally, Cody argues that FINRA and the SEC were wrong to

find that the three non-investment grade bonds he purchased for

James Bates were unsuitable.    Cody says that James Bates began

withdrawing $2,500 per month from his account--higher than the

original plan of $2,000 per month--and so Cody needed to find

investments that paid a higher yield. Since investment grade bonds

did not pay a sufficiently high yield, Cody said that he "had to be

creative" and invest in non-investment grade bonds; and in fact

Cody sold them months later at a profit.

                               -16-
               As the SEC noted, Cody's explanation is doubtful in light

of the timing of the purchases;4 but in any event Cody had no

warrant for departing from the agreed investment strategy without

Bates' agreement.            The fact that the investments ultimately turned

a profit does not make the purchases suitable when made.                         Eugene J.

Erdos, 47 S.E.C. 985, 988 n.10 (1983).                   The fault is taking the

risk without authority; whether the investment succeeds or fails

bears     on    civil        damages    but    does     not    excuse       professional

misbehavior.

               As    for     the   finding    that    Cody    engaged       in   excessive

trading, which Cody also attacks, it appears well supported by the

numbers of trades already set forth and by the large commissions

generated by in-and-out trades by which investments are acquired

and   resold        within    weeks    or    even    days.     Such     a    strategy   is

inappropriate for unsophisticated investors who desire a low-risk

strategy to protect their retirement savings.                   See Rafael Pinchas,

54 S.E.C. 331, 338-39 (1999).

               Cody says that the enforcers focused on only twelve

months for Lenore DeSimone and on sixteen months for James Bates

and should have obtained numbers for the entire life of each

account; but a year or more is not an insubstantial period and if

      4
      Cody purchased the Ahold bonds before James Bates' first
increased withdrawal, and he purchased the Calpine and Royal
Caribbean bonds within days of James Bates' first increased
withdrawal.

                                             -17-
a representative engages in unsuitable excessive trading for a

meaningful period of time, he should not be excused by the fact

that there was some other time that he may not have engaged in

excessive trading.       See Jack. H. Stein, 56 S.E.C. 108, 118 n.30

(2003).

             In a variant of this argument, Cody criticizes the

findings for concentrating on Lenore DeSimone's IRA instead of

considering all of the DeSimones' accounts together; but Lenore

DeSimone indicated that the accounts had different objectives, with

the IRA meant for safe bonds but with some other accounts geared

toward more aggressive or risky investments.              So the focus was

entirely appropriate.       See Frederick C. Heller, 51 S.E.C. 275, 279

(1993).

             Next, Cody notes that FINRA did not find that he was

engaged in excessive trading with the wrongful intent of enriching

himself.     But while subjective intent is relevant to churning

charges under the anti-fraud regulation of Rule 10b-5, Mihara v.

Dean Witter & Co., 619 F.2d 814, 821 (9th Cir. 1980), NASD's

suitability rule is violated when a representative engages in

excessive trading relative to a customer's financial needs, Erdos

v.   SEC,   742   F.2d   507,    508   (9th   Cir.   1984),    regardless   of

motivation, First Sec. Corp., 40 S.E.C. 589, 592 (1961).

             Lastly, Cody stresses the fact that one of the exhibits

offered     against   him   on   the   excessive     trading   charge,   which

                                       -18-
presented turnover and commission to equity ratios for James Bates'

accounts, turned out to have errors and was excluded.    Cody then

suggests that somehow the errors infected the entire analysis. The

panel admitted the other exhibits that underpin the charge; and the

Hearing Panel, Appeals Panel and SEC scrupulously avoided relying

on the flawed evidence.

          Affirmed.

                               -19-