Cody v. Sec. & Exch. Comm'n

• Citation: 693 F.3d 251
• Decision Date: 07 September 2012
• Docket Number: No. 11–2247.,11–2247.
• Parties: Richard G. CODY, Petitioner, v. SECURITIES AND EXCHANGE COMMISSION, Respondent.
• Court: United States Courts of Appeals. United States Court of Appeals (1st Circuit)

693 F.3d 251

Richard G. CODY, Petitioner,

v.SECURITIES AND EXCHANGE COMMISSION, Respondent.

No. 11–2247.

United States Court of Appeals,First Circuit.

Heard July 30, 2012.

Decided Sept. 7, 2012.

Stephen Z. Frank with whom Law Office of Stephen Z. Frank was on brief for petitioner.

Daniel Staroselsky, Senior Counsel, Securities and Exchange Commission, with whom Mark D. Cahn, General Counsel, Michael A. Conley, Deputy General Counsel, Jacob H. Stillman, Solicitor, and Randall W. Quinn, Assistant General Counsel, were on brief for respondent.

Before BOUDIN, HAWKINS ^* and THOMPSON, Circuit Judges.

BOUDIN, Circuit Judge.

Richard G. Cody seeks review in this court of an administrative determination, sustained by the Securities and Exchange Commission (“SEC”), that Cody mismanaged various brokerage accounts under his supervision. The original determination including sanctions was made by the Financial Industry Regulatory Authority (“FINRA”). A reasonably full description of the underlying events and evidence is required.

In 1996 Cody became a “registered representative” in the securities industry, that is, a person who has passed an examination administered by FINRA and obtained a license to solicit, purchase, and sell securities while working with a member firm of FINRA. In practice, his clients often allow him to exercise de facto control over their accounts, whereby he consults the clients about general strategies but routinely executes specific trades on behalf of his clients without first asking for their authorization.

During his career he has worked for several different brokerage houses including Merrill Lynch and Salomon Smith Barney but between 2001 and 2005, he worked at Leerink Swann & Co. (“Leerink”). In 2003–2004, he made investments for two couples—Richard and Lenore DeSimone and James and Emma Bates—certain of which are the centerpiece of this case. These four were near or in retirement, were not skilled investors, and expressed no interest in acquiring speculative investments for the accounts at issue.

The DeSimones told Cody they desired investments that would be relatively safe but that would provide steady income they needed to fund their retirement. Lenore DeSimone had held a 401(k) that carried mutual funds for about twenty years, and the DeSimones had also held savings accounts, savings bonds, and a small account previously managed by another broker. At issue are two of the DeSimones' several accounts: Lenore DeSimone's IRA and a joint account. For both the IRA and the joint account, the DeSimones listed an investment objective of “long-term growth.”

The DeSimones asked Cody to pursue a strategy of investing in safe, highly-rated bonds with maturity dates of around ten years. They told Cody they were relying on his expertise to execute this strategy in a way that would protect their investments. On Cody's records, the IRA listed a risk tolerance of “moderate” while the joint account listed a risk tolerance of “speculation,” but Lenore DeSimone testified that she believed that Cody filled out the risk tolerance entry, and Cody conceded that the DeSimones were not interested in speculation.

James and Emma Bates were friends of the DeSimones, who introduced them to Cody, and in February 2003, James Bates opened an IRA with Cody. James Bates' IRA initially contained assets of $380,046; James Bates hoped that the account would generate a monthly income of $2,000, which equated to an annual return of approximately 6.3 percent. In his account opening forms, James Bates listed an investment objective of “income” and a risk tolerance of “low.” Cody advised James Bates that he could achieve the desired income while maintaining low risk by investing in bonds.

In February 2003, Cody invested money from James Bates' IRA and the DeSimones' joint account in the Credit Suisse First Boston Mortgage Securities Corp. IndyMac Manufactured Housing Passthru (the “Credit Suisse Security”), a fixed-income security. Cody invested $86,500 from James Bates' IRA (23 percent of the total account) and $31,725 from the DeSimones' joint account (13 percent of the total account) in the security. The Credit Suisse Security was collateralized by installment sales contracts and installment loans for mobile homes.

The Credit Suisse Security was one of eleven “tranches” of securities collateralized by the same set of assets; its tranche was eighth out of the eleven in order of priority. This meant that the security was eighth in line to receive payments, and fourth out of the eleven to bear losses if the borrowers defaulted on their payments.The security carried a 7.105 percent coupon and had a stated maturity of February 2028, but the borrowers had the option of prepaying the underlying installment loans and contracts.

Cody invested his clients' funds in the Credit Suisse Security after it was recommended by a colleague at Leerink, Timothy Skelly, who specialized in fixed-income securities. Skelly gave Cody basic information— e.g., the issuer, the coupon percentage, the date of maturity, the nature of the collateral and the chance for prepayment—and gave him a printout from Bloomberg, but Cody did not seek out further information.

Cody knew that the security had an A rating, but did not know that it had been downgraded from AA by Fitch in October 2002. When asked whether he “really understood” the security at the time of the investments, Cody admitted, “At the time I sold it to them I didn't really look at a CMO [collateralized mortgage obligation] to be significantly different than any other bond; obviously, I've learned quite a bit since then.” Cody bought the security the day after Skelly first mentioned them.

Over the next year, the Credit Suisse Security was downgraded several more times, with the Fitch rating declining to CCC in February 2004. The market price of the security dropped from $104 in February 2003 to $41 by February 2004. Over the next three months, Cody sold the DeSimones' investment at a loss of $17,377 (55 percent of their initial investment) and James Bates' investment at a loss of $56,868 (66 percent of his investment).

In 2003, Cody invested James Bates' money in three non-investment grade bonds. A bond with a rating of BBB- or higher from Standard and Poor's or Fitch or Baa3 or higher from Moody's is considered investment grade. Non-investment grade bonds, often referred to as “junk” bonds, have a rating of BB+ or lower from Standard and Poor's or Fitch or Ba1 or lower from Moody's, and are considered to be speculative, with a higher degree of credit risk. Fabozzi, Bond Markets, Analysis, and Strategies 162–63 (6th ed.2007).

These investments were made in May 2003, when Cody purchased Ahold Financial USA Inc. bonds, and in June, when he purchased Calpine Corp. and Royal Caribbean Cruises, Ltd. bonds. The Ahold and Calpine bonds were rated B1 by Moody's, and the Royal Caribbean bonds were rated Ba2 by Moody's. These bonds totaled about 23 percent of the market value of James Bates' IRA. Between July and November 2003, Cody sold all of the bonds, realizing a small gain on the investment, but the ratings were nevertheless for speculative grade bonds.

Cody engaged in frequent trading in 2003 and 2004 in James Bates' and Lenore DeSimone's IRAs. Cody made 140 trades (84 purchases and 56 sales) in Lenore DeSimone's IRA from June 2003 through May 2004. He engaged in a pattern of in-and-out trading, purchasing several securities and then selling those same securities just weeks later. The purchases totaled more than $1.3 million, while the average value of the account was just $421,000.

The trades generated over $36,000 in commissions to Leerink, with Cody personally getting over $14,000 in commissions. During that period, the account had a turnover ratio (annual purchases over average account value) of 3.4 and a commission to equity ratio of 8.7 percent, meaning that the investments in the account would need to earn approximately 8.7 percent in annual returns just to break even after commissions.

In James Bates' account, Cody made 108 trades (69 purchases and 39 sales) from February 2003 through May 2004. Although there was not sufficiently precise information available to calculate turnover or commission ratios for this account, Cody made purchases of approximately $1.7 million during the 16–month period, when the total value of the account at the end of the month was always less than $475,000.

In addition, Cody employed a strategy of in-and-out trading and generated over $41,000 in commissions for Leerink, of which over $17,000 went to Cody. Around May 2004, Emma Bates questioned Cody about the trading in James Bates' account, and the level of trading in both James Bates' and Lenore DeSimone's accounts subsequently declined.

Cody also seemingly misled his clients in a number of his monthly reports by reporting bonds at par value, without a clear indication that this was so even when their market value was well below that figure, significantly overstating the value of their portfolios. After Cody left Leerink, Cody settled with the Bateses and DeSimones, agreeing to compensate the DeSimones $20,000 and the Bateses $56,000 for their losses on the Credit Suisse Security, but he delayed the required reporting of this information to FINRA for over two years.

On January 11, 2008, the Department of Enforcement of FINRA filed a complaint against Cody. FINRA is a self-regulatory organization (SRO) that regulates professionals and firms in the securities industry, inheriting the responsibilities of two earlier similar bodies. Under the Securities Exchange Act, SROs such as FINRA can discipline members with penalties including expulsion, suspensions, and fines but must provide a hearing and written opinion and allow an administrative appeal. Loss, Seligman & Paredes, 6 Securities Regulation 199–200.

The complaint alleged violations of NASD Rule 2310 and NASD Rule 2110. ¹ Rule 2310 requires:

In...