NASD REGULATION, INC.

OFFICE OF HEARING OFFICERS

SOURCE CITE

NASD Conduct Rule 2110

RR borrows money from customers to cover personal trading losses, but failed to affirmatively disclose to member firm when asked on annual form. Nine month suspension, $10,000 fine payable on terms, and prohibited from certain personal trading during repayment.

In 1987, James S. Davenport joined NASD member firm J.J.B. Hilliard, W.L. Lyons, Inc. ("Hilliard"), where he served as a registered representative. In 1994, Davenport started trading OEX puts and calls in his personal account; unfortunately, there were days when he lost as much as $125,000. By 1999 his personal losses on such activity amounted to $700,000, and he realized he had a gambling problem. Hilliard was apparently aware of the mounting nature of these losses, but decided not to take any action; perhaps in consideration of his role as one of the firm’s top producers.

Prior to reaching this personal nadir, Davenport had grown a book of business that totaled just under $83 million in assets and he was annually grossing nearly $664,000 in commissions . However, as a result of his mounting OEX losses, Davenport had borrowed in excess of $1.5 million from 26 of his customers. Each loan was documented by a promissory note, which bore fair market rate interest.  Hilliard may have been aware of one of these loans.

Hilliard's Compliance Manual prohibited employees from borrowing money from a customer and to implement that policy the firm distributed an annual form entitled "Prohibited Activities List." ("Prohibited List"). Question 9 on the Prohibited List asks whether an RR had borrowed any money from a customer. In returning a signed copy of the Prohibited List for 1997, 1998, and 1999, Davenport did not disclose the customer loans.

By 1999, several Hilliard brokers had left that member to join Dean Witter. Initially, Davenport declined the offer; but when Dean Witter subsequently offered him a $278,000 signing bonus, he saw a chance 1) to repay some of his loans and 2) to cease his risky options conduct (which he presumably continued in hopes of generating enough profits to further reduce his loan obligations). Upon accepting Dean Witter’s offer, he gave his secretary $5,000, gave his church $10,000, and applied the remaining $263,000 plus $105,000 from his IRA account towards reducing the principal amount of the customer loans.  Further, Davenport voluntarily decided not to open a personal margin account at Dean Witter and accordingly ceased further speculative options trading.

Within a year of his arrival at Dean Witter, in January 2000, an anonymous letter was sent to Dean Witter, NASD, and SEC complaining that Davenport had taken a personal loan from the author’s mother and disclosing further loans from other Dean Witter customers. The correspondence was  likely likely sent by a disgruntled co-worker or someone who had some ax to grind with Davenport.

When Dean Witter confronted Davenport with the letter, he forthrightly admitted the full extent of the loans. Notwithstanding, Dean Witter fired him and NASDR commenced an investigation. Following his termination by Dean Witter, Davenport obtained a sales job with a veterinary supplies company owned by one of his former customers. He presently earns about $60,000 per year.

Davenport apparently never missed an installment payment until Dean Witter fired him. As a result of his termination, he spoke to each customer who had lent him money and renegotiated payment terms. Following the agreements to reschedule the remaining payments, Davenport continued to meet his obligations on the $400,000 in remaining debt.

NASDR charged Davenport with violating NASD Conduct Rule 2110, which imposes "high standards of commercial honor and just and equitable principles of trade." Essentially, Davenport was charged with submitting false certifications about the loans to Hilliard. Consistent with the manner in which he comported himself during the investigative phase of this matter, Davenport represented himself during the proceedings and admitted the allegations against him. He conceded that he submitted the false reports in order to avoid getting fired. However, to his credit, he did not attempt to justify nor excuse his conduct. Nonetheless, NASDR purportedly offered to settle the matter for a six-month settlement and a fine, but when negotiations could not be successfully concluded, then sought at the hearing a $10,000 fine and a one-year suspension in all capacities. Davenport asked for a hearing for the limited purpose of contesting sanctions. He argued that as of the date of the hearing, he had already been out of the industry for nearly two years and that any further suspension would be unwarranted in light of the attendant facts and circumstances.

Many RRs, compliance professionals, and public advocates think that it is illegal for any registered person to obtain a loan from a public customer. Not so. In fact, as the Davenport decision clearly declares: "the Department carefully points out, there is no statute, regulation, or rule that prohibits such borrowing." The  mere failure to make timely payment of a customer loan is not necessarily a violation. What does raise such loans to improper conduct is when there was bad faith or unethical conduct involved, e.g., no intention of ever making payment, overreaching with a senior citizen; mischaracterizing the loan as an investment, etc. However, regardless of industry rules and regulations, many firms either prohibit such loans outright or require ongoing disclosure --- and many states view such activity as improper, if not illegal (depending on the circumstances).

In determining the sanctions to be imposed upon Davenport, the Hearing Panel clearly noted that it was not considering the legality of the loans --- as such was not an issue --- but merely Davenport’s misconduct in covering up their existence. The panel further noted that neither Hilliard, Dean Witter, nor any customer lost any money and that Davenport was "forthright and honest" when finally confronted about his activities. He had fully cooperated with Dean Witter and NASDR, and not one customer complained about any loan. Further, the panel noted that Davenport had dealt with his gambling problem before Dean Witter’s discharge and his motivation in accepting the signing bonus was to accelerate repayment of the loans. Additionally, the panel took notice of Davenport’s remorse and his representation that if he were allowed to re-enter the industry it would permit him to undertake repayment of the loans sooner than anticipated.  Similarly, he had no prior disciplinary history. 

This Hearing Panel went to great lengths to fashion sanctions to fit the violation. First, Davenport was suspended for nine-months, but given full credit for the two-years he had already been out of the industry. Effectively, the imposed suspension is deemed served. Second, although Davenport was fined $10,000, that fine will be payable in accordance with an installment plan agreeable to NASDR, taking into account his ongoing satisfaction of his loan repayments. Any default would permit NASDR to accelerate the balance due on the fine. I have spoken and written extensively as to the inappropriateness of regulators stepping between an RR and the public, and, in essence, interpositioning the regulator to intercept funds that rightly belong to the public for itself. As I wrote in "The Father of the Bride" in the April 2002 issue of Registered Rep. Magazine, "It still strikes me as unseemly that the NASD or the SEC collect millions of dollars in fines but public customers’ awards frequently go unsatisfied." The Hearing Panel's implementation of the fine in Davenport is inspired and shows a commonsense approach. Finally, in an understandable abundance of caution owing to his options/gambling problem, Davenport was prohibited from leverage trading in his own account until he has repaid the customer loans and the fine.

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