FREE-RIDING:
AS IN THERE'S NO FREE LUNCH

On September 24, 1998, the Securities and Exchange Commission (SEC) issued an Opinion In the Matter of the Application of JOHN M.W. CRUTE1934 Rel. No. 40474, Admin. Proc. File No. 3-9428, in which the SEC affirmed the NASD's findings that:

• Registered general securities representative Crute purchased securities in a number of initial public offerings that rose to an immediate premium at the opening of secondary trading ("hot issues");
• failed to notify his member firm in writing that he maintained a securities account at a second firm (his former employer); and
• failed to notify the second firm in writing that he had subsequently become associated with another member firm.

The SEC also sustained the NASD's sanctions of a Censure, $3,544.27 fine, and assessed costs of $541.50.

First, Let's Agree On The Ground Rules

Before dealing with the substantive issues in Crute, the SEC disagreed with the NASD's procedural assertion that the standard for review of its decision was limited to whether the NASD's findings of violation are supported by substantial record evidence. Citing 19 of the Securities Exchange Act, the SEC unequivocally rejected any suggestion by the NASD that the federal regulator's review would be anything but a fully independent review of the record, and asserted its obligation to make its own findings, not merely to consider those of the NASD's.

Not That I'd Ever Do It, But... How Did They Catch Him?

During a routine examination of Crute's former employer's (Firm A) underwriting activities, the NASD checked the names of purchasers of a hot issue against its Central Registration Depository ("CRD"). CRD records reflected that Crute was registered with another member firm (Firm B) at the time he purchased the shares. NASD investigators discovered that Crute purchased stock in a number of initial public offerings that were hot issues through a personal securities account that he continued to maintain with Firm A after his registration with Firm B.

In the course of its investigation, NASD staff questioned employees at both firms to determine whether Crute notified each firm in writing of his connection with the other firm. According to statements provided by persons at Firm A, Crute left that firm on the understanding that he was retiring from the securities business, would be pursuing other interests, would remain subject to a non-compete agreement contained in his employment contract, and would leave both his customer accounts and his personal investment account at the firm. In return Firm A agreed not to require Crute to repay immediately principal and interest on an outstanding $20,000 loan the firm had made to him. Neither Firm A's general counsel nor its broker handling Crute's personal account knew that Crute intended to associate or register as a representative with another firm. Similarly, Firm A did not know that Crute maintained a personal securities account at Firm B.

You Got It Wrong... See... I Was Never Associated With Those Guys

Crute acknowledges that he submitted a "Uniform Application for Securities Industry Registration or Transfer" (Form U-4) through Firm B and was registered with Firm B during the relevant period, but urged the SEC to disregard this fact, as his continued registration with Firm B during the relevant period was inadvertent. Crute claims that when Firm A discovered his intention to move to Firm B and threatened to sue him for breach of his non-compete agreement, he informed Firm B orally that he would not be able to join the firm and assumed that Firm B filed documents with the NASD necessary to terminate his status as a general securities representative. According to Crute, Firm B's failure to terminate his registration resulted from the inexperience of Firm B's compliance officers.

Consequently, Crute argued that:

• he did not believe he was registered with Firm B;
• he had no reason to believe he was;
• he was reasonable in assuming that Firm B had filed a "Uniform Termination Notice for Securities Industry Registration" (Form U-5); and
• his hot issue purchases occurred during a nine-month period he spent touring the United States, not employed by Firm B, and allegedly out of contact with Firm B.

Crute argues that in determining whether he is an associated person, the SEC should disregard the fact of his registration with Firm B (in part, because Firm B failed to file a Form U-5, and, in part, because he really wasn't employed by Firm B during the relevant period). However, the NASD urges that the mere fact of Crute's filed Form U-4 (notwithstanding Crute's alleged good faith belief that Firm B filed a U-5) compels associated person status.

According to the NASD By-Laws, Crute should have received a copy of the Form U-5 within 30 days after his termination from Firm B. Crute acknowledged that he never received a copy. The SEC held that Crute's failure to receive the Form U-5 should have caused Crute to investigate further the status of his registration. Consequently, the SEC found Crute's defense unreasonable, because without a copy of the Form U-5, he lacked a reasonable basis for his belief that he was no longer registered.

If You Quack Like a Duck, Walk Like a Duck, and Look Like a Duck...

Article I (m) of the NASD By-Laws, amended and renumbered as Article I (ee), codifies the NASD's interpretation that any natural person registered with the NASD is a "person associated with a member," without regard to that person's employment responsibilities. However, the impetus behind that interpretation was a recognition by the NASD that certain case law held that any person whose job title or position is not specifically identified in the Association's definition of "associated person" (regardless of whether the individual is registered under an NASD member firm) may not be considered an associated person if he or she is not directly engaged in the securities business. The SEC concluded that Crute was an associated person, and liable for such violations arising from that status. In reaching that conclusion, the SEC considered several factors.

Limited Doesn't Mean Non-Existent

Crute's admitted purpose in submitting his Form U-4 through Firm B was to associate with Firm B and to handle some securities accounts at the firm. Crute conducted such securities-related activities as he believed were consistent with non-compete agreement and with a break from day-to-day employment. Crute's involvement with Firm B increased as his non-compete agreement with Firm A neared its expiration. Notwithstanding that Crute limited his activities at Firm B because of his agreement not to compete with Firm A and Firm A's threats of suit, Crute nonetheless engaged in Firm B's securities business, and, thus, was an "associated person" of Firm B.

Compensation

Before he traded in the hot issues, Crute recommended that certain Firm A customers transfer their accounts to Firm B. These customers followed Crute's recommendation and Crute consequently received compensation from Firm B for transactions that occurred both before and during the period Crute was trading the hot issues. The SEC found the fact of compensation to be a further indication that Crute was in the securities business, even if on a limited basis, and properly categorized as an associated person.

Salary Not Determinative

The SEC pointedly dismissed Crute's defense that he did not receive a salary from, and was not in day-to-day communication with, Firm B. Whether or not an individual is an "employee" is not determinative for associated person status.

Associated Person Are Subject To The Free-Riding Interpretation

The NASD found that Crute engaged in free-riding by purchasing at the initial offering price stock in five hot issues where the initial aftermarket trades in each stock were effected at a premium over the offering price. In a disciplinary proceeding that charges free-riding, it is immaterial, except in connection with fixing the nature of the sanctions to be imposed in the public interest, whether the respondent was aware that he was violating the NASD rule. Crute, given his association with Firm B at the time of the stock transactions at issue, acted in contravention of the Free-Riding Interpretation, even if he did not believe he was an associated person subject to the prohibition on hot issue purchases.

Piling On?

The NASD also found that Crute violated another NASD rule when he failed to notify Firm B in writing of his personal securities account at Firm A, and to notify Firm A in writing of his association with Firm B. Crute acknowledges that he never informed either firm in writing of his connection to the other firm, but claims that each firm had constructive knowledge of such connection. Crute claims that Firm A became aware of his overtures to Firm B and threatened to sue him for breach of the non-compete agreement. Crute also claims that he orally informed his superiors at Firm B that he maintained an account at Firm A. The SEC held that constructive awareness and verbal notification are insufficient under the terms of a NASD rule, which requires notification "in writing." The SEC also rejected Crute's defense that he did not knowingly engage in the violation, by noting that this rule has no knowledge component.

The SEC affirmed the NASD's sanctions, which it deemed minimal under the attendant circumstances. In considering what sanction was in the public interest, the SEC reviewed the mitigating factors outlined by the NASD:

• The minimal profit Crute received from the hot issue purchases suggested to the NASD that Crute did not deliberately attempt to circumvent the NASD Rules.
• The NASD concluded that his violations were primarily the result of ignorance and inattention.
• In addition, the NASD specified that Crute has not been the subject of any previous disciplinary actions during his 29 years as a registered representative.

Given these considerations, the NASD departed from the Sanction Guideline for free-riding violations. The NASD imposed a base fine of $2,500 (the minimum amount specified in the Guideline), and based the remainder of the fine on Crute's actual profit of $1,425 on these stocks, rather than on a larger amount equaling what the Guideline refers to as "transaction profit" -- that is the greater of the immediate aftermarket unrealized profit (the price determined to be the immediate aftermarket price times the number of shares minus the public offering price) or the actual profit. The NASD also chose not to impose any additional sanction for Crute's notification failures.