Avello, Nicholas T. v. SEC ( 2006 )

UNPUBLISHED ORDER
Not to be cited per Circuit Rule 53
United States Court of Appeals
For the Seventh Circuit
Chicago, Illinois 60604
Submitted May 26, 2006*
Decided May 26, 2006
Before
Hon. RICHARD A. POSNER, Circuit Judge
Hon. ILANA DIAMOND ROVNER, Circuit Judge
Hon. ANN CLAIRE WILLIAMS, Circuit Judge
No. 05-2850
NICHOLAS T. AVELLO, On Petition for Review of an Order of the
Petitioner, Securities and Exchange Commission
v. No. 3-10391r
SECURITIES AND EXCHANGE
COMMISSION,
Respondent.
ORDER
Nicholas T. Avello is a certified public accountant who was sanctioned with a
letter of caution by the National Association of Securities Dealers for submitting
inaccurate financial reports. He now petitions for review of an order of the
Securities and Exchange Commission upholding the disciplinary action, arguing
that rules he was held to have violated do not apply to him, and that, even if they
do, the standard by which his conduct was judged was too high. We deny the
petition.
*
After examining the briefs and the record, we have concluded that oral
argument is unnecessary. Thus, the appeal is submitted on the briefs and the
record. See Fed. R. App. P. 34(a)(2).
No. 05-2850 Page 2
We briefly sketch the regulatory scheme that led the NASD to focus on
Avello. The NASD, a self-regulated agency registered with the Commission as a
national securities association under the Securities and Exchange Act of 1934, see
15 U.S.C. § 78o-3(a), adopts rules governing the conduct of its members and
enforces compliance with federal securities laws and Commission rules and
regulations. Otto v. SEC, 253 F.3d 960, 964 (7th Cir. 2001). One Commission
regulation, known as the net capital rule, requires brokers and dealers to maintain
a specified level of net worth to protect their customers from the firm’s potential
insolvency. See 17 C.F.R. § 240.15c3-1. A firm’s net worth is determined from
books, records, and reports that the NASD and Commission require members to
keep and submit. See 17 C.F.R. §§ 240.17a-3, 240.17a-5. Depending on whether the
broker or dealer carries or clears transactions or customer accounts, it is required to
submit either monthly or quarterly reports known as the Financial and Operational
Combined Uniform Single, or FOCUS reports. 17 C.F.R. § 240.17a-5(a)(2). Under
NASD rules, the title of persons responsible for the accuracy of these reports is
“Limited Principal—Financial and Operations,” otherwise known as a FINOP.
NASD MANUAL, Membership and Registration Rule 1022(b)(2). A FINOP is
“associated with a member,” and must be a natural person who is registered with
the NASD and has passed a qualifying examination. Id., Rule 1022(b)(1); NASD
MANUAL, Bylaws of the NASD, Art. 1(dd). A FINOP’s duties include:
(A) final approval and responsibility for the accuracy of financial
reports submitted to any duly established securities industry
regulatory body;
(B) final preparation of such reports;
(C) supervision of individuals who assist in the preparation of
such reports;
(D) supervision of and responsibility for individuals who are
involved in the actual maintenance of the member's books and records
from which such reports are derived;
(E) supervision and/or performance of the member’s
responsibilities under all financial responsibility rules promulgated
pursuant to the provisions of the Act;
(F) overall supervision of and responsibility for the individuals
who are involved in the administration and maintenance of the
member's back office operations; or
No. 05-2850 Page 3
(G) any other matter involving the financial and operational
management of the member.
NASD MANUAL, Rule 1022(b)(2).
Avello contracted to work as a FINOP for Hudson Knight Securities, Inc.
(HKS) and remained in that position from 1995 until 1997. During that period the
NASD became aware that HKS was experiencing difficulty meeting its required
level of net capital and began monitoring HKS. Eventually the NASD determined
that the firm had improperly accounted for certain items in its FOCUS reports
which, if properly accounted for, would have shown that the firm had conducted
business while below its required level of net capital. When the NASD or its
Department of Enforcement believes that an associated person has violated rules,
regulations, or securities laws, it may request authorization from the Office of
Disciplinary Affairs to file a complaint. Id., Procedural Rule 9211. If alleged to
have violated a statute or certain NASD rules, a respondent may propose that the
NASD’s Chief Hearing Officer select a Market Regulation Committee Panelist for a
Hearing Panel. Id., Procedural Rule 9221(a)(3). And that’s what happened here.
In 1998 the Department filed a complaint against Jonathan Webb, the Chairman
and half-owner of HKS, and Avello (but did not name the firm itself) that was later
vetted before a Hearing Panel.
The complaint alleged ten causes, only three of which implicated Avello. The
charges against Webb alone included allegations that HKS, acting through him,
effected securities transactions on days when it failed to maintain the minimum
required net capital; failed to maintain the level of net capital Webb agreed to with
the Commission; violated rules and regulations requiring the accurate maintenance
and submission of books, records, and reports; and conducted business without
employing properly qualified principals required by NASD rules. The causes
involving Avello concerned only the financial reporting obligations; the complaint
alleged that HKS, acting through both Webb and Avello, had failed to maintain its
required level of net capital, had kept inaccurate books and records, and had filed
inaccurate FOCUS reports. Those causes were based on the firm’s violation of five
rules: Exchange Act Rules 15c3-1, 17a-3, and 17a-5, and NASD Conduct Rules 2110
and 3110. Exchange Act Rule 15c3-1 is the net capital rule. Rule 17a-3 requires
brokers and dealers to keep various books and records current, while Rule 17a-5
requires them to file the FOCUS reports. See 17 C.F.R. §§ 240.15c3-1, 240.17a-3,
240.17a-5. NASD Rule 2110 requires members to “observe high standards of
commercial honor and just and equitable principals of trade,” while Rule 3110 is the
NASD counterpart to the Exchange Act rule regarding the proper keeping of books
and records. The complaint did not charge Avello with violating NASD Membership
and Registration Rule 1022(b)(2)—the NASD provision specific to FINOPs.
No. 05-2850 Page 4
Before any hearings were conducted, Avello stipulated that five items were
not accounted for properly in HKS’s books, records, and reports. The first is a debt
HKS owed to American Express for charges incurred by HKS’s officers. At the time,
Avello believed that the underlying charges were personal to the officers and thus
did not record the unpaid balance as a firm liability, though he acknowledged that
the account agreement with American Express—which he did not read until
later—made all charges the responsibility of the firm as well as the individual
cardholders. Second is a $60,000 sole-recourse loan that Avello initially recorded as
a liability, but later removed from HKS’s books on Webb’s word that it had been
paid, even though it had not. The third item is a lease agreement for office
furniture and equipment. Instead of reading the agreement and recognizing that
the lease should have been capitalized and the future payments recorded as a
liability, Avello treated it as a rental contract and recorded the monthly payments
as “rent” based on a bank debit memorandum with that notation. Fourth, Avello
included certain receivables, technically called payment-for-order-flow receivables,
owed to HKS by another broker-dealer as allowable assets on the firm’s FOCUS
reports, even though he stipulated that they should not have been treated as
allowable assets. Finally, Avello failed to account for debts HKS owed various
vendors and delivery services because the firm would not provide him with complete
and accurate information. When submitting the firm’s FOCUS report to the NASD,
Avello highlighted these last debts in a letter, stating that he had not been able to
review any of the underlying documents and was unable to verify the accuracy of
the amounts reported.
Avello also stipulated to three more accounting errors made as a consequence
of Webb’s unsuccessful attempt to increase HKS’s net capital. The first is a $50,000
note executed by Webb on behalf of HKS that was paid down to $47,000 by January
1996. Webb never disclosed the note to Avello, so Avello never recorded it as a firm
liability from late 1995 through 1996 when Webb replaced the note with a $50,000
revolving line of credit. Avello also booked as good capital a $65,000 check drawn
on Webb’s personal checking account and deposited into HKS’s checking account,
even though at the time Avello booked the check Webb lacked sufficient funds in his
checking account to cover it. Third is a $125,000 account at Smith Barney that
Avello booked as good capital even though it was not because it was encumbered by
a non-HKS officer’s authority to withdraw funds from the account.
Although Avello stipulated to the improper accounting, he denied
responsibility for the resulting rules violations on the ground that he had
adequately performed his role as FINOP. The Hearing Panel disagreed and held
him liable for all the accounting errors except those pertaining to the $50,000 note,
the American Express debt, and the $125,000 account at Smith Barney. With
respect to the net capital rule, the Hearing Panel concluded that Avello’s errors
made him responsible for four of the days when HKS conducted securities
No. 05-2850 Page 5
transactions while its net capital was below the required level. The Hearing Panel
imposed a $5,000 fine, $500 in costs, and a 30-day suspension.
A party dissatisfied with a decision of the Hearing Panel may initiate what
becomes a three-step process of appeal. The first step is an appeal to the National
Adjudicatory Council (NAC). NASD MANUAL, Procedural Rule 9311. The next is a
petition for review by the Commission, 15 U.S.C. § 78s(d)(2), and then, if requested,
we will review the final decision of the Commission, 15 U.S.C. § 78y(a)(1).
Avello followed these steps, some more than once. Initially the NAC held
Avello responsible for the same inaccuracies that the Hearing Panel did, though it
added responsibility for the American Express debt that the Hearing Panel had
been willing to overlook. The NAC confirmed that Avello was not responsible for
the unbooked $50,000 note or the account at Smith Barney, and further absolved
him of responsibility for misbooking Webb’s $65,000 check because Avello could not
have known the check was no good on the date he booked it. The NAC therefore
modified the Hearing Panel’s decision, holding Avello responsible for only one day’s
net capital violation, rather than four, and setting aside the 30-day suspension. On
Avello’s petition for review, the Commission conducted an independent review of
the record but ultimately agreed with NAC.
Avello then petitioned this court for review of the Commission’s decision.
Before responding to Avello’s brief to this court, the Commission moved to remand
the case, having discovered an error in the calculation of HKS’s net capital position
on the single date for which Avello was held responsible. We granted the request.
The Commission remanded the case to the NAC to clarify Avello’s liability for the
net capital violation.
Upon further review the NAC concluded that it mistakenly had taken into
account the unbooked $50,000 note for which it had absolved Avello, and that
ignoring that liability he would not be responsible for any net capital violation. The
NAC did not completely exonerate Avello, however, because it still considered him
responsible for the five accounting errors, though it did reduce the sanction to a
letter of caution, the minimal sanction under NASD practice for a rules violation,
see In re Martin Lee Eng, Exchange Act Release No. 44224, 2001 WL 427969, at *3
(Apr. 26, 2001). Avello again petitioned for review by the Commission. His petition
raised for the first time additional arguments related to his recordkeeping and
reporting violations, which the Commission deemed waived because they could have
been raised in the earlier proceedings. The Commission therefore once again
affirmed the findings of the NAC and sustained the sanction.
This case has now made its way back to us. Our review is limited to the
Commission’s decision sustaining the NASD’s sanctions and we treat the findings of
No. 05-2850 Page 6
fact as conclusive “if supported by substantial evidence.” 15 U.S.C. § 78y(a)(4); see
Otto, 253 F.3d at 964. Avello’s brief lists some ten issues, but we think he makes
two principal arguments.
His first is that Exchange Act Rules 17a-3 and 17a-5 do not apply to him
because those rules literally apply to brokers or dealers, not to FINOPs. He is
correct that Exchange Act Rules 17a-3 and 17a-5, “by their terms, apply to broker-
dealers, not to persons associated with broker-dealers.” Davrey Fin. Servs. Inc.,
Exchange Act Release No. 51780, 2005 WL 1323032, at *4 n.13 (June 2, 2005)
(naming Rules 17a-3 and 17a-4, but analysis is applicable to Rule 17a-5 because it
too is limited to broker-dealers). Indeed, in its brief the Commission concedes that
HKS, not Avello, violated the regulations. And in its decisions the Commission
often attributes the violation of a rule to the securities firm while characterizing the
limited principal as responsible for the firm’s violations. See id.; In re William H.
Gerhauser, Exchange Act Release No. 40639, 53 S.E.C. 933, 938-40 (Nov. 4, 1998)
(discussing net capital requirement as firm’s obligation); In re Gilad J. Gevaryahu,
Exchange Act Release No. 33038, 51 S.E.C. 710, 710 (Oct. 12, 1993) (referring to
FINOP as “responsible for the firm’s failure to comply” with net capital,
recordkeeping, and reporting requirements); In re George Lockwood Freeland,
Exchange Act Release No. 34-32192, 51 S.E.C. 389, 390 (Apr. 22, 1993) (same).
But Avello could violate Exchange Act rules indirectly through NASD
Membership Rule 1022(b). That rule, akin to an accomplice-liability statute,
incorporates violations of other provisions. If Avello, as the FINOP, caused HKS to
violate an Exchange Act rule by maintaining inaccurate records or submitting
inaccurate reports, then he is responsible for the Exchange Act violation. Thus,
because HKS violated Exchange Act recordkeeping and reporting rules, Avello was
responsible for the violations under Rule 1022(b)(2).
Avello counters that he was never charged with violating Rule 1022(b) and so
to hold him liable for violating it contravenes the procedural safeguards prescribed
by 15 U.S.C. § 78o-3(h)(1). True, the underlying complaint does not reference Rule
1022(b), but Avello has not explained how that omission has prejudiced him. See
Rehman v. Gonzales, 441 F.3d 506, 509 (7th Cir. 2006) (explaining in immigration
context that reviewing court will not set aside agency decision on basis of claimed
procedural error unless mistake or error caused prejudice). Nor do we see how it
could have; the Hearing Panel first put him on notice of the application of Rule
1022(b)(2) in 1999, yet Avello waited to argue that he lacked notice of that rule until
five years and four rounds of review later. Anyway, the language of the complaint,
alleging that HKS violated the rules through Avello, was enough to alert him to the
NASD’s theory of liability.
No. 05-2850 Page 7
We turn then to his second main argument. Avello argues that even if Rule
1022(b)(2) applies to him, he was held to too high a standard under that rule. He
asserts that he has effectively been held to a standard of “strict liability” for
guaranteeing the accuracy of the firm’s reports when he was simply “the hired hand
used to perform the Firm’s net capital calculations.” He suggests that a
reasonableness standard should govern and that his conduct should be compared to
what reasonable accountants (though we suspect he means bookkeepers)—not
auditors—do. The Commission does not articulate a precise standard; in its brief
the Commission emphasizes the plain language of Rule 1022(b)(2) making a FINOP
responsible both for the accuracy of the firm’s FOCUS reports and for supervising
the persons who generate the records underlying the reports, but the Commission
does not argue that Avello could have been sanctioned for inaccuracies about which
he did not know and could not have known. Indeed, the Commission points out that
Avello was disciplined because he booked information that he either knew to be
incorrect or with reasonable inquiry would have discovered to be incorrect.
We need not decide, then, whether the Commission could adopt or enforce a
standard making a FINOP strictly liable for inaccuracies in a firm’s FOCUS reports
or the underlying documentation. Avello himself proposes that liability should
attach for unreasonable conduct, and there is substantial evidence to support that
Avello acted unreasonably in accounting for the American Express bills, the sole-
recourse loan, the lease agreement for office furniture and equipment, the
receiveables owed to HKS, and the vendor and delivery service debts. With respect
to the American Express debt, the account agreement HKS had with American
Express stated that the charges were the responsibility of the company as well as
the individual; Avello should have looked at the agreement to determine whose
responsibility the charges were, especially when he discovered that the individual
cardholders had been in default on their payments for several months. There is no
explanation for Avello’s failure to continue booking the sole-recourse loan as a
liability; he had booked it as a liability for several months in 1996 but then failed to
book it as a liability thereafter based on (what turned out to be a false)
representation by Webb that it had been paid. As for Avello’s failure to capitalize
the furniture lease and book the overall liability rather than show the monthly
payments as rent, he admitted that he booked the lease as he did based on a bank
debit memo and that he would have recorded it correctly had he taken the time to
look at the lease itself. Given that a FINOP must examine the underlying
documentation before classifying an item, see Gerhauser, 53 S.E.C. at 947 n.40, we
find no fault with the Commission’s determination that these were errors for which
Avello was responsible.
Likewise, the Commission’s determination that Avello bore responsibility for
two other inaccuracies is supported by the record. Avello had been twice informed
by NASD staff that the receivables were not the type that could have been booked
No. 05-2850 Page 8
as allowable assets for purposes of the firm’s net capital calculation. Yet for the
following four months he continued to book them as allowable assets. Finally,
Avello admitted that, despite knowing he was not getting complete and accurate
information from HKS regarding various debts owed to vendors and delivery
services, he nevertheless submitted FOCUS reports that did not include the debts
as liabilities. Although he informed the NASD by letter that he was unsure of the
report’s inaccuracy, he essentially violated one rule (requiring accurate reports) to
save the firm from violating another (requiring quarterly reports). But if Avello
found himself unable to discharge his duties as FINOP, the proper course was for
him to resign, not to file reports with attached caveats. See Freeland, 51 S.E.C. at
392. Thus, there was substantial evidence to support the Commission’s
determination that Avello failed to satisfy his duties as a FINOP in these five
instances.
Avello’s remaining arguments for a different standard do not convince us to
alter our view. That he disclaimed responsibility for the accuracy of the firm’s
books and records in an engagement letter with HKS matters not; one cannot
contract out of statutory duties. See U.S. Sec. Clearing Corp., Exchange Act
Release No. 35066, 52 S.E.C. 92, 98 n.30 (Dec. 8, 1994). Nor are we persuaded that
the fact that he worked only four hours a month for HKS calls for absolving him of
liability. See Gevaryahu, 51 S.E.C. at 712-13. His policy argument that smaller
firms will not be able to afford FINOPs who perform the duties as diligently as
required by NASD rules is irrelevant but, regardless, has no support in this record.
All we know is that Avello and HKS came to an agreement about how he was to be
compensated, and that in retrospect Avello believes the contract price was too little
for what the NASD expected of him. Finally, despite his contention that a FINOP
ought to be treated as someone who simply compiles numbers, rather than as an
auditor, the requirements of a FINOP are different than those of a bookkeeper. The
position of a FINOP is unique and governed solely by NASD rules. So even though
auditors examine underlying documents, the Commission has decided that a FINOP
should do so as well. See Gerhauser, 53 S.E.C. at 947 n.40; In re James S. Pritula,
Exchange Act Release No. 40647, 53 S.E.C. 968, 972 (Nov. 9, 1998) (explaining that
FINOP should have ascertained whether check had been deposited before treating
it as asset).
Avello’s other arguments merit little discussion. He argues that he could not
have violated NASD Conduct Rule 2110 because the Commission did not find that
he acted in bad faith. (As with the Exchange Act rules, Avello is liable for the firm’s
violation of Rule 2110 only through Rule 1022 because Rule 2110 applies to
“members,” which Avello was not.) But the Commission does not require a finding
of bad faith when the predicate for violating Rule 2110 is the violation of another
NASD or Exchange Act rule, see In re Chris Dinh Hartley, Exchange Act Release
No. 50031, 2004 SEC LEXIS 1507, at *10 n.13 (July 16, 2004); Gerhauser, 53 S.E.C.
No. 05-2850 Page 9
at 942, and we have already explained that substantial evidence supports that
Avello was responsible for other violations. Avello’s arguments that the
Commission was required to find that he “controlled” a person who committed a
violation under 15 U.S.C. § 78t(a) or that he acted “willfully” under 15 U.S.C.
§ 78o(b)(4) were not presented until his return to the Commission after remand and
are accordingly waived. See United States v. Parker, 101 F.3d 527, 528 (7th Cir.
1996) (“A party cannot use the accident of a remand to raise in a second appeal an
issue that he could just as well have raised in the first appeal because the remand
did not affect it.”); W. Va. v. EPA, 362 F.3d 861, 871 (D.C. Cir. 2004) (refusing to
consider arguments raised for first time after remand that were not raised in
agency rulemaking proceedings conducted prior to remand). His argument that he
is not responsible for HKS’s reports because they were submitted by his corporation
and not signed by him is frivolous because a FINOP, as a “person associated with a
member” is, by definition, a natural person. See NASD MANUAL, Bylaws of the
NASD, Art. 1(dd).
We note that the various agency decisions recognize Avello’s good-faith
efforts at accurate financial reporting. But those efforts do not excuse his failure to
comply with the duties of a FINOP, and that failure justifies the lenient sanction
upheld by the Commission. We therefore DENY the petition for review.