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NASD Letters of Caution
| On April 1, 1999, Davrey Financial Services, Inc. (DFSI)
concluded separate stock-repurchase agreements
("Agreements") with two DFSI shareholders. Pravin Davrey (Davrey),
who was president, chief executive officer, chief financial officer,
limited principal -- financial and operations ("FINOP"),
and compliance officer of DFSI, assigned the drafting of the
Agreements to an outside accountant whose name he chose out of the
telephone directory. Davrey claimed that he directed the accountant
to draft a stock-repurchase
agreement under which the debt would be Davrey's and not
DFSI's. However, DFSI and
the shareholders were the sole parties to the resulting
Agreements. Pursuant to the Agreements, the shareholders sold their
shares to DFSI in return for a negotiated purchase price paid in
regular monthly installments, plus interest. Those payments
were made from DFSI's operating account, but Davrey testified
that the payments were essentially funded by his reduced
commissions. Although Davrey executed personal guarantees in favor
of the shareholders as addenda to the Agreements, he was only
required to assume DFSI's obligations if the firm ceased to exist or
was unable to fulfill its obligations under that Agreements.
Notwithstanding a May 18, 1999 letter of caution warning of a
similar 1997 violation (and there were additional letters of caution
issued in November 1996 and September 1997 for record-keeping
matters), DFSI failed to
record the debts created by the April 1999 Agreements as liabilities
in its records, reports, and net capital calculations. Consequently,
the NASD deemed that DFSI's books, records and net capital calculations were inaccurate
on April 1999 and remained inaccurate until the error was corrected
in August 2000. During the sixteen months the error remained
uncorrected, DFSI had at least eight unreported net capital
deficiencies; and incurred two subsequent net capital deficiencies
on November 30 and December 31, 2001(resulting from DFSI's operating
losses that also went unreported). |
Prior
Caution Unheeded?
On
May 18, 1999, NASD staff issued to DFSI a letter of caution that addressed
record-keeping and net capital violations caused by DFSI's treatment of a
December 1997 stock repurchase agreement between DFSI and two
shareholders. DFSI had failed to enter DFSI's debt under the 1997
repurchase agreement on its books, or account for the debt in calculating
its net capital position, resulting in net capital deficiencies from
December 1997 through February 1998. The letter of caution stated that
"a liability should have been recorded on the Firm's books and
records."
In
DFSI's May 25, 1999 response, Davrey stated that, although "I
disagree with your position on the [stock-repurchase agreement], I am
appreciative of the fact that this matter is now behind us" and also
gave assurances that DFSI had retained an accountant to assist in
achieving future compliance.
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The NASD Recordkeeping/Net Capital
Charges
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NASD charged that DFSI and Davrey (the Applicants)
violated record-keeping and net capital rules, and that those violations
were egregious. Applicants characterize their violations as "a
clerical error," and Davrey contended that he believed in good faith
that the debt was not a DFSI liability.
NASD found that the Applicants failed to maintain accurate
books and records and conducted a securities business with insufficient
net capital in violation of Exchange Act Rules 17a-3, 17a-4, and 15c3-1 2/
and NASD Conduct Rules 2110 and 3110.
For the recordkeeping and net capital violations, NASD
suspended Davrey for two years from associating as a FINOP and as a
general securities principal and required him to requalify in both
capacities. NASD censured DFSI and fined it $15,000. Davrey was not fined
because he had filed for bankruptcy.
The Applicants appealed to the SEC.
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The
Rules
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Exchange
Act Rule 17a-3 specifies how books and records broker-dealers
must be kept and maintained
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Exchange
Act Rule 17a-4 specifies the reports broker-dealers must
file.
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NASD
Conduct Rule 3110 requires members to keep and preserve their
books and records in conformity with all applicable laws,
rules, and regulations.
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Exchange
Act Rule 15c3-1 requires broker dealers to maintain their net
capital above an applicable minimum.
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NASD
Conduct Rule 2110 requires NASD members to observe high
standards of commercial honor and just and equitable
principles of trade. Violations of SEC rules are violations of
NASD Conduct Rule 2110. |
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SEC Considers the Appeal
Was DFSI
liable for the payments to the selling shareholders under the Agreement?
The SEC believed that the plain language of the Agreements
made it clear that DFSI (and not Davrey) was liable for the payments
But
shouldn't Davrey get some credit for "good faith" for executing
personal guarantees on April 19, 1999?
Cleary, Davrey urged the NASD and the SEC to look beyond
the four corners of the Agreement and judge him by his intentions.
He pointed out that among the reasons he thought the Agreement was a
personal one between him and the selling shareholders (and thus not
required to be on DFSI's books) was because he agreed to personally
guarantee the firm's payments. The SEC pointedly noted that this
assertion "undercuts" his claim of good faith. Here are
the points they considered in reaching that determination:
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The guarantees made Davrey's
obligation contingent on a DFSI default, which suggests that he
understood that the debt was -- and intended that it should remain --
DFSI's;
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Davrey received and answered the NASD May
18, 1999 letter of caution. The letter of caution stated that a
stock-repurchase agreement very similar to the recently executed
Agreements should have been recorded as a liability on DFSI's books.
At a minimum, the SEC said Davrey should have reexamined DFSI's treatment of the
Agreements; and
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Davrey did not record the Agreements as a DFSI
liability or ask NASD staff for advice regarding the proper accounting
treatment of the Agreements.
Accordingly, the SEC sustained the NASD sanctions against
the Applicants on these counts.
The NASD Advertising Charges
| A PRIOR WARNING:
On
November 25, 1996, NASD staff issued to DFSI a letter of caution regarding
some of its advertisements. NASD found that the examined materials had not
been submitted for pre-use review, omitted disclosures appropriate for
options advertising materials, and lacked a balanced presentation of
options trading risks. The letter of caution also indicated that DFSI
distributed sales literature that failed to include:
- an options disclosure
document,
- a statement warning that options were not
suitable for all investors, and
- any specific statements of
the risks of options investing to balance statements of the advantages
provided by options (and gave an exaggerated statement regarding the
returns to be expected from a specific type of options investment).
NASD
also found that an internet advertisement had not been submitted to NASD
as required, failed to make a balanced presentation of the risks of
options investing, and did not include the name and address of a person
from whom potential customers could obtain a current copy of the relevant
options disclosure document.
THREE YEARS LATER:
DFSI
paid $4,000 for a thirty-minute television appearance by Davrey on November 9, 1999,
on a Los Angeles
area cable television program. Davrey spoke briefly about stocks,
options, and options trading, answered DFSI-scripted questions from the
program's host, and answered questions called in by viewers. Davrey
testified that the program on which he appeared did not generate any
business for DFSI or any new customer accounts.
During the broadcast,
Davrey claimed that he would provide callers with a "Stocks to
Watch" list, which identified stocks that would "rise substantially" and "really, really
take off."
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The NASD said he did not mention during the broadcast the
possibility that the stocks included in the list could lose value. |
Davrey also
discussed a "million dollar plan," an investment strategy
that he claimed would turn a $15,000 initial investment into $1 million
after seven years. While
Davrey noted that the plan might not be fully successful, he asked viewers
if making only $200,000 to $300,000 on that investment would be "any
harder to take." Although Davrey claimed that the plan was already
being used, it is not clear how many DFSI customers were participating,
what results they achieved, or if the plan existed at all.
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The NASD said that Davrey did not explain that this plan depended on
aggressive use of margin and options trading, which is not suitable for
every investor, and failed to disclose the risks in this strategy. |
Davrey also
promised to provide viewers who called DFSI several items that, he
claimed, would improve their investment success. These items included the
"Davrey Master Key," which he stated was an aid to picking
stocks, and his book, which he described as containing techniques used by
DFSI's most successful clients to make large amounts of money starting
from small initial investments. He also promised to provide testimonials
from successful clients. Davrey was unable to provide any documentary evidence
that either the book or the testimonials had ever existed. Davrey claimed
they were lost during an office move.
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The NASD characterized the "Master Key"
as a
skeletal outline of technical terms and jargon that would be useless to a
reasonable investor. |
Davrey
mentioned that his customers came from "every walk of life." He gave several examples of options purchases with very small
initial investments, implying that options could be a suitable investment
for an investor of modest means without mentioning any specific
corresponding disadvantages that options could pose for such investors.
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The NASD determined that
Although Davrey stated generally that customers should invest only funds
they could afford to lose in options strategies, his descriptions of the
opportunities offered by options investing were not accompanied by equally
specific assessments of the risks faced by options investors. For example,
he did not mention that a decline in the price of the stock
could cost the option purchaser the entire amount of the investment, and
that the loss could occur rapidly. |
NASD found that Applicants violated
NASD Conduct Rules 2110 and 2210 when Davrey made exaggerated, misleading,
and unwarranted statements, omitted required disclosures, and made
unwarranted promises of specific results when he appeared on a television
program promoting DFSI. NASD also found that Applicants failed to submit
the material on which the program was based to NASD for pre-use approval
and otherwise failed to comply with rules governing advertising involving
options in violation of NASD Conduct Rules 2220 and 2110.
For the
advertising violations, NASD suspended Davrey for two years from
associating as a general securities principal and as a general securities
representative. NASD censured DFSI and fined it $20,000. NASD also ordered
Applicants to submit all advertising to NASD's Advertising Department for
pre-use Davrey was not fined
because he had filed for bankruptcy. |
NASD
Advertising Rules
Under NASD
Rules 2210(a)(1) and 2220(a)(1), advertisements include any material that
is published in electronic media, including television.
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NASD Conduct Rule 2210 sets out NASD's advertising rules,
requiring that advertisements, in general, must provide a sound basis for
evaluating the facts regarding the investment or service offered and must
not omit any material fact or qualification if to do so would cause the
advertisement to be misleading. Prohibits any
exaggerated, unwarranted, or misleading statements or claims. NASD Conduct
Rule 2220, which governs its members public communications regarding
options, requires that all options advertising must be
submitted to NASD
at least ten days prior to use.
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NASD
Conduct Rule 2220 prohibits false
statements, omissions of material facts, exaggerated, unwarranted, and
misleading statements or claims. Requires a specific
statement in advertisements that options are not suitable for all
investors and prohibits any suggestion that options may be suitable for
all investors. Any statement referring to the potential advantages of
options must be balanced by an equally specific statement of the
corresponding risks. A public communication with respect to options must
also contain the name and address of a person from whom the appropriate
current options disclosure document can be obtained. |
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SEC Considers the Appeal
What role
did Davrey's apparent credibility play with the NASD's and SEC's
determinations?
Frankly, it seems a fair inference that the NASD had
questions about Davrey's sincerity and that the SEC gave great deference
to hte NASD's position. It seems that during a
February 2000 routine NASD examination of DFSI, an examiner asked if DFSI
had engaged in any advertising in the past twelve months. Davrey stated
that the Firm had not. When shown DFSI accounting documents reflecting a
payment from DFSI to the television station in connection with the
November 1999 broadcast, Davrey claimed that he had forgotten about it.
But folks
forget things all the time, especially when under pressure during an
examination. Isn't that taken into account?
You would hope so, but during NASD's subsequent investigation, Davrey gave investigative
testimony stating that he was not sure why he failed to submit the
materials related to the program for review. Later, at the NASD hearing, Davrey
stated that he thought submission of the program-related material was
unnecessary because DFSI had previously submitted advertising dealing with
similar issues that had been approved. NASD staff testified that DFSI had
not submitted any such material to NASD. Still later in the hearing,
Davrey stated that he believed that the broadcast material had been
submitted. Davrey ultimately admitted that the material should have been
submitted, was not submitted, and that the failure to do so was his
responsibility.
So what
was he supposed to do . . . lie to the NASD?
No . . . never! But one thing most skilled defense
lawyers will warn their clients about is to never speculate. If you
don't remember, then say "I don't remember." Memory is a
trick thing, and it also plays tricks on you --- what you really think you
recall may simply be a false memory. Be careful because once you
start guessing at where and when, you lock yourself in and if you start
changing your answers down the road, your credibility becomes an issue.
Here, Davrey's response went from "I forgot about that," to
"I don't know why I didn't submit it" to "I didn't think I
had to submit it" to "I thought it had been
submitted." That's a deadly progression.
Did
Davrey intentionally or recklessly violate the advertising rules, or, as
he argues, were his violations merely "ineffective advertising"?
The SEC agreed with the NASD that Davrey should be held
to the intentional/reckless standard. At the threshold, the SEC
agreed with NASD that Davrey's appearance
on the program contained numerous statements that were exaggerated,
unwarranted, and misleading, and that he failed to disclose potential
risks and made unwarranted promises of specific results.
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Davrey's
discussion of the "Stocks to Watch" list included unwarranted
promises of future performance, that the stocks were expected to
"rise substantially" and "really, really take off" in
violation of NASD Conduct Rule 2210. He did not disclose,
that their prices could also fall.
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Davrey's discussion of the
"million dollar plan" contained no risk disclosure, no
description of the risky strategies on which it was based, and promised
specific results without a reasonable basis in violation of NASD Conduct
Rule 2210.
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The
description of the "Master Key" was misleading; Davrey described
it as an analytical tool that could help an inexperienced investor make
better stock picks, when it was no more than a sketchy outline filled with
technical jargon and useless to a reasonable investor.
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Promises to provide
copies of a non-existent book and testimonial letters also were
misleading. The description of the book as a collection of techniques used
by successful DFSI customers was an unwarranted promise of success.
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During the television program, Davrey referred to Wade Cook, a
lecturer on investment topics, and stated that investors seeking to follow
Cook's strategy should employ a broker who was familiar with that
strategy. Applicants objected to NASD's admission of evidence regarding Wade
Cook and criticisms of Cook's investing techniques. Applicants argued that
the evidence was irrelevant and had the intended effect of prejudicing the
Hearing Panel by tying Applicants to Cook, who Applicants assert was
extremely unpopular with NASD. However, Davrey made several references to
Cook in the course of the advertisement. The SEC said there was no unfairness in
admitting the evidence; especially since Applicants, in fact, offered one of the exhibits,
the "Wall Street Workshop Manual," to which they were
objecting.
What about
"no harm, no foul" --- it appears that the television program
didn't bring in a single account?
The SEC said that the fact that DFSI gained no new customers is irrelevant.
Moreover, the SEC seemed to want to send a message by noting that this
was
not the first time that NASD had warned
Applicants about compliance with NASD advertising rules. DFSI had received
a letter of caution on November 25, 1996 regarding the failure to submit
options advertising material to NASD for review and approval before use.
DFSI and Davrey, therefore, were on notice that they were required to file
options advertising material. The November 1996 letter of caution and
Davrey's repeatedly changing stories force the conclusion that the failure
to file the materials related to the November 1999 television appearance
was a reckless violation of NASD rules.
SEC Decision
Sustained NASD's findings. Note that the NASD suspended DFSI's membership in May 2003 for
failing to file an annual audit report. According to the Central
Registration Depository, in March 2005, NASD cancelled DFSI's membership
for failure to pay fees. Davrey is no longer associated with an NASD
member.
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