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A Sad Story Of Regulators Simultaneously Doing Too Much And Too Little

Alan Wolper
Ulmer & Berne LLP

October 21, 2021

Not too long ago, a single, small BD experienced a bizarre combination of regulatory overzealousness and regulatory indifference, by the SEC and FINRA, respectively. These things, sadly, happen all the time, but what happened to this unfortunate firm presents an excellent case study in regulators who simply do not wield their considerable prosecutorial discretion in any sort of fair, or predictable, fashion.

Let’s start with FINRA. Spartan Securities Group was – notice the portentous use of the past tense here – a very small BD in Florida with a modest retail business, but also with a niche business in filing Forms 211, i.e., the application necessary for any BD to begin offering quotes on an issuer’s securities. Unless and until some BD files a Form 211, no one can serve as a market maker for the issuer’s shares. While perhaps a bit out of the realm of what “typical” BDs do, filing Forms 211 is not a particularly difficult thing, as the information contained in the form is pretty much supplied by the issuer itself. A BD is not required under the applicable rule, i.e., FINRA Rule 6432, to independently corroborate the information supplied by the issuer. It is worth noting that BDs may not receive any compensation in exchange for filing a Form 211, so issuers hoping to see their shares covered by market makers may not simply pay a BD to accomplish this. Despite its small size, Spartan filed a significant percentage of all Forms 211 filed by all BDs. Finally, but importantly, in addition to this business, Spartan also maintained a modest proprietary account in which it traded its own capital.

Unfortunately, two things happened in close succession for Spartan, neither one of which was good.

First, according to court filings, in early March 2019, Spartan’s head trader made a series of unauthorized short trades in Bio-Path Holdings Inc. in the firm’s prop account. These trades were big enough that they exceeded the trading limits imposed on the head trader by Spartan. Sadly, the share price kept climbing. By the time the short positions were all covered, at great expense, it eventually resulted in a loss to Spartan, as well as Axos Clearing, Spartan’s clearing firm, in excess of $16 million. Obviously, this caused a big hit to Spartan’s net capital, a hit from which the firm never recovered.

Second, the SEC took an interest in Spartan’s 211 business, and eventually filed a complaint in federal court against the firm and three of its principals alleging a variety of things, but principally that in filing the Forms 211 for 19 companies – out of approximately 1,500 such forms that Spartan filed overall – they failed to discover that these companies were shams, and that the individuals behind these 19 issuers were perpetrating a fraud on the investing public. In their defense, the defendants argued that they had done nothing wrong, that they were unaware of anything untoward by the issuers, that they had done everything that FINRA and the SEC required of a BD that files a Form 211, and that the SEC was attempting to hold them to a standard of conduct in filing the Forms 211 that was not articulated in the applicable rules or any of the guidance that had been previously issued.[1] By the time the case made its way to trial, Spartan was already out of business as a result of the unauthorized short sales described above. The SEC persisted, however.

This is a sad tale, to be sure. But, that’s not the point of this post. The point is to ask you to consider the roles that FINRA and the SEC played, and just how oddly they did their jobs.

First, FINRA. I want you to take the minute it will cost you to read this excerpt from the findings contained in the explained Award that resolved the arbitration that Spartan filed against its former trader (and which came to involve Axos, as well):

*Responsibility has been defined as “the state of being held as the cause of something that needs to be set right” (Merriam-Webster Thesaurus). The Panel finds that [head trader] Respondent Scott Richard Reynolds (“Reynolds”) is solely responsible for the losses suffered by Third Party Respondent Axos Clearing LLC (“Axos”) and Claimant Spartan Securities Group, Ltd. (“Spartan”).

*The witnesses called by Spartan and Axos were credible and Reynolds’ testimony was not. Moreover, the evidence of unambiguous text messages, created contemporaneously with the occurrence of operative events were highly probative, especially when compared to contradictory testimony proffered by Reynolds.

*Reynolds, a licensed securities professional, initiated the short sale position in BPTH on or about March 6, 2019, creating an open-ended risk of loss to Spartan/Axos. Primarily using Axos’ money and being aware of Axos’ lending limits and its right to reject trades and close trading positions, he was caught in a short squeeze, causing Spartan to violate its net capital requirement, which as a member of FINRA, it self-reported.

*As a licensed individual, trading through a FINRA member firm’s proprietary account, Reynolds had no discretion to disregard the explicit directives of Spartan’s compliance officer to cover the BPTH short on March 6, 2019 and in fact, exacerbated the highly risky short position by adding to it, in contravention of his supervisor’s instructions and his own trading limits.

*The Panel finds that Reynolds’ unlawful actions were not merely negligent or reckless, but intentional. This is evidenced by numerous acts such as fictitious trade entries made by Reynolds into Spartan’s control/Brass system in order to make it appear as if the BPTH short position was materially smaller than the true amount. Reynolds’ explanation for these “wooden” tickets defied common sense. His further assurances that there was a “block-order” or big seller coming in late on March 6 was likewise false. These actions/representations, among others, caused both Spartan and Axos to reasonably rely to their detriment. Reynolds did not want to close out the short position on March 6 despite orders to do so by his employer. He lied to keep it open and concealed his intent from Spartan/Axos. Those two entities reasonably relied, suffering large losses, including the destruction of Spartan’s on-going business.

This is pretty strong language from the panel. “Intentional.” “Lied.” “Concealed.” And look – I am not saying the hearing panel was right or wrong; indeed, Mr. Reynolds is, to my understanding, pursuing a Motion to Vacate the Award that could eventually result in a different outcome. But, what I AM saying is: what do you think FINRA did about this? What action did FINRA take against the guy whom the panel concluded was “solely responsible” for the $16 million in losses that put Spartan out of business?

Nothing. Not. A. Thing.

Well, let me be clearer, actually. FINRA actually did take action. But not against Mr. Reynolds. No, rather remarkably, even though it never charged Mr. Reynolds with anything,[2] FINRA chose instead to go after his supervisor, i.e., the guy, according to the hearing panel, whose “explicit directives” to close out the short positions were ignored by Mr. Reynolds, the guy to whom Mr. Reynolds supposedly lied. According to the AWC that FINRA exacted from the supervisor, although Mr. Reynolds had “executed a series of transactions in Spartan’s proprietary account that resulted in short positions in a biotechnology stock that exceeded the trading limits set forth in the firm’s WSPs,” his supervisor “became aware of the short positions in the biotechnology stock in the morning on March 6, 2019, but failed to modify or restrict the trader’s market access until close to the end of the trading day.”

So, according to FINRA – not me – Mr. Reynolds did, in fact, exceed his written trading limits, resulting in uncovered short sales that caused Spartan to incur a $16.6M loss, but instead of charging him for that, they charged his supervisor for not stopping it sooner.[3]

Huh.

Chew on that while I shift our attention to the SEC.

In its complaint, the SEC leveled 14 separate charges against Spartan – defunct already – and three principals (one of whom, coincidentally, was – you guessed it – Mr. Reynolds’ supervisor). The case went to trial earlier this year before a jury. A three-week trial, at that. And what do you think the jury did? Well, it dismissed 13 of the 14 claims, leaving only a single finding of liability – a finding that is being challenged. And, notably, all charges against Mr. Reynolds’ supervisor were dismissed.

So, what do you call a case where 13 of 14 claims you made are rejected by the jury? I suppose it’s a matter of perspective. If you’re the SEC, i.e., the plaintiff, you call it a big win! It’s like a guy batting .125 who manages to eke out a broken-bat single and then celebrates his resounding hitting prowess.

There are lots of details here that I’ve deliberately omitted in an effort to keep this at a readable length. But, truly, they’re not important, as they don’t change anything about the overarching observations I am making. (For an excellent discussion of the SEC trial, please see this article by the attorney who defended it.) FINRA, as everyone knows, will bring an Enforcement case at the drop of a hat, no matter what its senior management likes to say about how reasonable and understanding and non-adversarial they are. Yet, here, when presented with evidence at least suggesting that Spartan’s head trader had allegedly committed a variety of acts that not only resulted in the demise of Spartan’s business but which constituted a number of heady rule violations, FINRA simply ignored the trader.

This is simply inexplicable. Given the ticky-tack nature of many of the Enforcement actions I am called upon to defend, it is maddening that FINRA elected to take a pass here. And again, I am not saying this because I have anything against Mr. Reynolds; I mean, kudos to him for managing to avoid FINRA’s wrath. It’s just that I cannot fathom the decision-making process that must have taken place resulting in no action being brought against him. I can only hope that when the SEC performs its oversight exam of FINRA that it manages to find this case and ask some hard questions to Enforcement management regarding its charging decisions.

As for the SEC, they are guilty of the exact opposite crime: they were so anxious to bring a case against Spartan and its principals that they pretty much invented a new standard by which to gauge the respondents’ conduct in order to justify their zeal. Happily, the jury saw through this bit of trickiness, as reflected by the denial of 93% of the charges, and rejected the SEC’s argument that somehow the views of the staff, even published views, carry the same weight as actual law.

No one is perfect. But the sort of imperfection displayed here by FINRA and the SEC is more than just annoying; it demonstrates a sense of haughtiness, of being able to do whatever the heck they want, that suggests the system is not working. Broker-dealers, as well as the investing public, deserve a degree of consistency from the regulators in their charging decisions. That does not exist right now, and poor Spartan understands this better than anyone.

[1] According to the guidance available at the time, all Spartan needed to file a Form 211 was a “reasonable basis” for doing so.

[2] It is notable that in support of his Motion to Vacate, Mr. Reynolds extolls the fact that FINRA took no action against him.

[3] In the interest of fairness, it should be noted that by the time this Award was issued, FINRA had already lost its jurisdiction over Mr. Reynolds. But, it is also true that FINRA was well aware of these facts while it still had jurisdiction over Mr. Reynolds; it just decided not to bother to do anything.

https://www.jdsupra.com/legalnews/a-sad-story-of-regulators-7883832/