380 F.3d 112 (2nd Cir. 2004), 03-4883, D'Alessio v. S.E.C.

Docket Nº:03-4883.
Citation:380 F.3d 112
Party Name:John R. D'ALESSIO and D'Alessio Securities, Inc., Petitioners, v. SECURITIES AND EXCHANGE COMMISSION, Respondent.
Case Date:August 16, 2004
Court:United States Courts of Appeals, Court of Appeals for the Second Circuit
 
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380 F.3d 112 (2nd Cir. 2004)

John R. D'ALESSIO and D'Alessio Securities, Inc., Petitioners,

v.

SECURITIES AND EXCHANGE COMMISSION, Respondent.

No. 03-4883.

United States Court of Appeals, Second Circuit

August 16, 2004

Argued: Mar. 18, 2004.

Dominic F. Amorosa, New York, NY, for Petitioners.

Michael A. Conley, Jennings Attorney Fellow, Securities and Exchange Commission (Giovanni P. Prezioso, General Counsel; Eric Summergrad, Deputy Solicitor; Mark Pennington, Assistant General Counsel; Meyer Eisenberg, Deputy General

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Counsel, of counsel), Washington, DC, for Respondent.

Before: SACK and RAGGI, Circuit Judges, and TRAGER, District Judge.[*]

SACK, Circuit Judge.

The petitioners seek review of an order of the Securities and Exchange Commission (the "Commission" or the "SEC") sustaining the petitioners' termination by the New York Stock Exchange (the "Exchange" or the "NYSE") of their Exchange membership. The petitioners argue that: (1) the Exchange's partiality required its hearing officer to recuse himself from the disciplinary proceedings that resulted in the petitioners' termination; (2) the partiality of the Commission similarly required the Commission to recuse itself with respect to its review of the Exchange's order; and (3) the sanctions imposed by the Exchange were impermissible because they were disproportionately harsh.

BACKGROUND

The Petitioners and Their Relevant Conduct

In 1979, the petitioner John R. D'Alessio ("D'Alessio") began his career as a floor broker at the Exchange. He purchased a membership on the Exchange in December 1993. He operated as an independent floor broker1 until his suspension by the Exchange in February 1998.

By February 1996, D'Alessio had become an Exchange floor official. As such, he was responsible for answering the questions of other floor brokers about Exchange rules and their interpretation. During the period relevant to this appeal, D'Alessio was an employee of petitioner D'Alessio Securities, Inc., an Exchange member-organization ("D'Alessio Securities" or D'Alessio's "firm"). D'Alessio was owner, president, and director of his firm, and acted as the firm's floor broker. On February 25, 1998, the Exchange summarily suspended D'Alessio and his firm from Exchange membership and from access to Exchange services. Those suspensions set in motion the series of events that ultimately led to the present petition.

The Exchange is a self-regulatory organization ("SRO") subject to Commission oversight pursuant to 15 U.S.C. §§ 78c, 78f, 78s.2 With exceptions not relevant here, a federal statute and a Commission regulation make it unlawful for an SRO floor broker to trade for an account in which the broker has an interest or over which the broker exercises discretion. 15 U.S.C. § 78k(a) (1) ("Section 11(a)");3 17 C.F.R. § 240.11a-1 ("Rule 11a-1").4

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These prohibitions are designed to prevent floor brokers from exploiting short-term market information and opportunities that are available to them but unavailable to other investors. See NYSE, Exchange Act Release No. 41574, 70 S.E.C. Docket 106, 1999 WL 430863, at *1, 1999 SEC LEXIS 1290, at *3 (Jun. 29, 1999). The ban on proprietary or discretionary trading by floor brokers is further reflected in Exchange rules. See NYSE Rule 90(a), 95(a), & 111(a). D'Alessio and his firm--the petitioners--argue that during the period prior to their suspension from Exchange membership, senior Exchange officials were aware of violations of Section 11(a) and related rules, and yet tacitly encouraged floor brokers to engage in such activity.5

Exchange rules also prohibit floor brokers from "crossing trades" and "trading ahead," also called "frontrunning." See NYSE Rule 91 (crossing trades); NYSE Rule 92 (trading ahead, frontrunning). A broker "crosses trades" when he or she fills a customer's order by buying or selling a security from an account in which the broker has an interest. A broker "trades ahead" or "frontruns" when he or she receives a large order for a particular security from an institutional client and, before executing the larger trade, first executes trades in that security for an account in which the broker has an interest so as to anticipate and exploit the movement in price the larger trade is likely to cause. In addition, NYSE Rules 123, 410, and 440, which implement the record-keeping provisions for brokers and dealers contained in 17 C.F.R. §§ 240.17a-3 and 240.17a-4, require floor brokers to retain all of their trading orders for three years.

In 1994, the petitioners--D'Alessio and his firm--entered into a business relationship with the Oakford Corporation. They concede that until February 25, 1998, they "flipped" stocks for, and had a profit-sharing arrangement with, Oakford. Under the agreement with Oakford, D'Alessio and his firm were to receive seventy percent of net profits from Oakford trades, and were to absorb seventy percent of the account's

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losses. D'Alessio concedes that he did not know directly of other brokers with this sort of arrangement, that he did not recall asking anyone at the Exchange whether it was permissible, and that he had only a "general sense" of the rules barring trading by a floor broker for an account in which the broker had an interest. NYSE Hearing of Mar. 28, 2000, at 120.

Along with petitioners' seventy percent interest in the Oakford account, D'Alessio also had discretion over trades for the account. He used this discretion to "cross trades" for Oakford's benefit. And D'Alessio was vested with discretion to decide how many shares of a particular security he would trade for Oakford. At least once, D'Alessio changed the number of shares in an existing Oakford order without first contacting Oakford. The petitioners gave the Oakford account preferential treatment, "frontrunning" other customers for the benefit of the Oakford account.

Neither D'Alessio nor his firm complied with Commission regulations or Exchange Rules requiring brokers to maintain specified trading records. See 17 C.F.R. §§ 240.17a-3 & 240.17a-4; NYSE Rule 123, 410, & 440. Instead of keeping the records required by these detailed rules, see, e.g., NYSE Rule 410(a) (requiring Exchange members to "preserve for at least three years" all trading orders transmitted or carried to the Exchange floor), D'Alessio kept a box at his booth on the trading floor in which he put order tickets. As he himself described it, he threw away the contents "[w]henever the box got full." NYSE Hearing of Mar. 28, 2000, at 128. The amount contained in the box at any one time, he said, "could have been a year's worth, year and a half's worth, it could have been less." Id. The petitioners wisely do not seek to convince us that these record-keeping practices complied with Commission regulations or NYSE Rules.

Criminal Proceedings

On February 25, 1998, federal law enforcement officials (it is difficult to determine from the record who) arrested D'Alessio on a charge of violating Section 11(a). On the same day, the Exchange summarily suspended D'Alessio and his firm from Exchange membership and access to Exchange services. The Exchange acted based upon D'Alessio's floor brokerage activities involving Oakford.6 Also on the same day, the Commission filed a civil action against, among others, D'Alessio and his firm. See Oakford Corp., Litigation Release No. 15653, 66 S.E.C. Docket 1301, 1998 WL 75699, 1998 SEC LEXIS 311 (Feb. 25, 1998).7

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Meanwhile, the government instituted criminal proceedings against Oakford, D'Alessio, and other floor brokers associated with Oakford in the United States District Court for the Southern District of New York. Defendants other than D'Alessio pleaded guilty, see United States v. Oakford Corp., 79 F.Supp.2d 357, 359 (S.D.N.Y.1999), while the charges against D'Alessio were dismissed pursuant to a deferred prosecution agreement, D'Alessio v. NYSE, 258 F.3d 93, 97 (2d Cir. 2001).8 But in an opinion and order in connection with the sentencing of defendants in the case, the district court (Jed S. Rakoff, Judge) observed that the Exchange's interpretation of Section 11(a)'s prohibition of "discretionary" trading by a floor broker, which deemed a trade chosen by a floor broker not "discretionary" so long as the broker notified the customer of the trade prior to making it, was "anemic" and made a "mockery" of the statutory language. Oakford Corp., 79 F.Supp.2d at 362-63.

SEC Proceedings Against the Exchange

At about the time the criminal proceedings against the Oakford-related defendants were underway, the Commission launched an investigation into trading practices on the Exchange floor. It concluded that as a result of, among other things, "improperly restrictive rule interpretations," the Exchange had allowed independent floor brokers to disregard securities laws and Exchange rules. Letter from Lori A. Richards, Director, SEC Office of Compliance Inspections and Examinations, to Richard A. Grasso, Chairman and Chief Executive Officer, NYSE 1 (Sept. 14, 1998). On June 29, 1999, pursuant to a settlement agreement with the Exchange, the Commission issued an order concluding that the Exchange had been lax in policing trading by independent floor-brokers for trading involving accounts in which the brokers had an interest. The order instructed the Exchange to enforce the relevant rules. NYSE, Exchange Act Release No. 41574, 70 S.E.C. Docket 106, 1999 WL 430863, at *7-*10, 1999 SEC LEXIS 1290, at *21-*31 (June 29, 1999).

The Petitioners' Lawsuit

On December 14, 1999, D'Alessio and his firm instituted a lawsuit in the Supreme Court of New York, New York County, against the Exchange and three Exchange officials: Chairman Richard Grasso, Group Executive Vice-President for...

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