Horning v. S.E.C., 08-1038.

• Decision Date: 26 June 2009
• Docket Number: No. 08-1038.,08-1038.
• Citation: 570 F.3d 337
• Parties: Stephen J. HORNING, Petitioner v. SECURITIES AND EXCHANGE COMMISSION, Respondent.
• Court: U.S. Court of Appeals — District of Columbia Circuit

570 F.3d 337

Stephen J. HORNING, Petitioner v. SECURITIES AND EXCHANGE COMMISSION, Respondent.

No. 08-1038.

United States Court of Appeals, District of Columbia Circuit.

Argued November 13, 2008.

Decided June 26, 2009.

On Petition for Review of an Order of the Securities & Exchange Commission.

Thomas D. Birge argued the cause and filed the briefs for petitioner.

Dominick V. Freda, Senior Counsel, Securities & Exchange Commission, argued the cause for respondent. With him on the brief were Brian G. Cartwright, General Counsel, Andrew N. Vollmer, Deputy General Counsel, Jacob H. Stillman, Solicitor, and Randall W. Quinn, Assistant General Counsel.

Before: GARLAND and BROWN, Circuit Judges, and WILLIAMS, Senior Circuit Judge.

Opinion for the Court filed by Circuit Judge GARLAND.

GARLAND, Circuit Judge.

Stephen J. Horning, the former president and director of Rocky Mountain Securities & Investments, petitions for review of an order of the Securities and Exchange Commission (SEC). The Commission found that Horning failed to exercise reasonable supervision over two employees who violated the securities laws, and that he caused his firm to commit numerous statutory and regulatory violations. The Commission permanently barred Horning from associating with any broker or dealer in a supervisory capacity and suspended him for twelve months from associating with any broker or dealer in any capacity. Horning contends that these sanctions were arbitrary and capricious, that he was denied due process in his administrative hearing, and that a provision of the Securities Investor Protection Act of 1970 under which he was sanctioned is unconstitutionally vague. Because we conclude that the Commission's order was reasonable and supported by substantial evidence, and because Horning's other challenges are without merit, we deny the petition.

I

In 1980, Horning founded Rocky Mountain as a penny-stock firm in Denver, Colorado. By the turn of the 21 st century, Rocky Mountain had grown into a medium-sized broker-dealer, with approximately fifty registered representatives and more than 5,500 customer accounts. From 1981 to 2003, Horning served as president, director, financial and operations principal, compliance officer, and registered representative at Rocky Mountain. He was also the largest equity owner, holding nearly 40% of the shares at the time the firm closed.

Horning exercised substantial control over virtually every aspect of Rocky Mountain. He managed the firm, set policy, and oversaw daily operations. He had authority to hire and fire employees. He bore primary responsibility for ensuring compliance with the SEC's net capital, customer reserve, and reporting requirements. He established the firm's supervisory procedures and oversaw their implementation, and he alone supervised the operations and trading departments.

The first unmistakable sign that something was amiss at Rocky Mountain appeared in early 2001, when a routine SEC staff examination revealed that, from May 2000 to February 2001, the firm's head trader, Judy Clarke, had failed to document trades as required and the firm had suffered over $600,000 in unreported losses. Each time Clarke bought and sold stocks in Rocky Mountain accounts and executed trades on behalf of its customers, she was supposed to chronicle the transaction on a "trade ticket" and submit it to Horning for approval and to the accounting department for recordkeeping. The examination disclosed that Clarke had ignored these procedures for more than $800,000 in purchases. Two other Rocky Mountain employees—Leslie Andrade, the head of operations, and Tammy Steffen, the assistant director of compliance— knew about Clarke's unrecorded trades but did not tell Horning. Andrade was responsible for keeping the firm's books and records, working with its auditor, and preparing the Financial and Operational Combined Uniform Single Reports (FOCUS Reports) that broker-dealers must file regularly with the SEC. See 17 C.F.R. § 240.17a-5. Andrade reported to Steffen until the latter left the firm in the spring of 2001; from that time on, both Andrade and Clarke reported exclusively to Horning.

In March 2001, following the staff examination, the SEC's Central Regional Office sent Horning, in his capacity as president of Rocky Mountain, a deficiency letter outlining numerous concerns that required "immediate corrective action or response, without regard to any other actions that the Commission may take or require to be taken as a result of the examination." J.A. 696. Among other material deficiencies, the letter stated that Rocky Mountain had failed to: (1) calculate properly its net capital and customer reserves; (2) maintain accurate records of its assets and liabilities; (3) file accurate net capital computations in its annual audit reports; and (4) establish and employ adequate supervisory procedures for the preparation of its financial statements. In light of these failures the letter indicated, Rocky Mountain had violated the federal securities laws.

The deficiency letter also pointed to troubling language in the annual evaluations prepared by Rocky Mountain's auditor, Mortland & Co., a one-person company run by Horning's college friend, Herbert Mortland. Every year since the early 1980s, Mortland's reports had highlighted weaknesses in Rocky Mountain's internal controls and warned that they "result in more than a relatively low risk that errors or irregularities in amounts that would be material ... may occur and not be detected within a timely period." E.g., J.A. 674. The deficiency letter advised that, notwithstanding these warnings, Mortland's audits had been inadequate in scope to detect the firm's many net capital and reserve requirement failings. This, too, violated SEC rules.

Horning responded to the deficiency letter approximately one month later. His brief missive to the SEC struck a defiant tone. "In response to the alleged violations regarding [the rules discussed in the deficiency letter]," Horning began, "we can only say, that, after 20 years in business, we are obviously aware of the above referenced rules and how such things as firm related trading errors, improperly classified securities positions, and the resultant inaccurate clearing account reconciliations can impact all of them in a negative way." J.A. 697. Horning continued:

The only comment that we would like to make at this time is that these items certainly did not go undetected, as you say in your letter, and also that we would disagree with your statement that we do not have adequate written supervisory procedures to detect any inaccuracies in our clearing account reconciliations. In reality, the exact opposite was and is true.

Id. The letter concluded by assuring the SEC that "[t]he people at Rocky Mountain ... responsible for these actions have been spoken to and dealt with," and that "[t]he deficiencies and concerns addressed in your letter have all been remedied." Id. at 698.

Horning did take some remedial measures in response to the deficiency letter. For example, he reduced the percentage return that Clarke received on profitable trades. And he instructed Andrade to prepare daily "reconciliation reports" documenting that all executed trades were properly recorded and balanced in Rocky Mountain's books, along with daily "trade error reports" documenting any trading irregularities or unreconciled trades that had occurred.

For the most part, however, Horning preserved the operational status quo. Although he later testified that the conduct of Andrade and Clarke had been "[b]asically" dishonest, J.A. 287, he declined to fire them, fine them, or restrict their activities. Clarke continued to execute trades in the firm's proprietary account at her discretion, just as before. Andrade continued to manage all of the firm's books and records, just as before. Horning did not establish any procedures to monitor Clarke's trading or to check the accuracy of Andrade's recordkeeping. Nor did he put in place any kind of operations manual. Similarly, although Horning testified that he was "very angry" at Mortland for failing to identify the problems flagged in the deficiency letter and that Mortland was "partially at fault," id. at 283, Horning declined to fire Mortland or to demand new procedures for his subsequent audits. And he continued to take no action in response to Mortland's warnings about inadequate internal controls.

Moreover, Horning's implementation of those supervisory procedures that did exist was often perfunctory. Horning testified that he spent only two minutes reviewing each FOCUS Report he signed, and that he reviewed the reconciliation reports one day a week, for just ten seconds. Rocky Mountain kept some customers' funds in an omnibus money market account managed by a brokerage firm named Reich & Tang Services, which sent daily reports of transactions in the account. Horning never checked whether the figures in Andrade's daily reports or the firm's books matched the figures sent by Reich & Tang. Nor did he review executed trades, seek to verify the trade error reports, or inquire into whether the errors identified in the reports had been corrected.

This laissez-faire approach to supervision turned out to be a costly mistake, as Andrade and Clarke soon began to commit serious fraud. From April 2002 through January 2003, the two conspired to conceal approximately $6.5 million in losses that Clarke accrued in unreported, unauthorized trading in Rocky Mountain's accounts. They did this by entering fictitious profitable trades into the Rocky Mountain record system, omitting unprofitable trades, and then plundering $4.5 million in customer funds from the Reich & Tang account (as well as a substantial amount of firm funds) to pay for the losses. The firm's books, records, and reports became increasingly unmoored from reality. For more than six months in 2002, the reconciliation reports and financial...