McCarthy v. S.E.C., Docket No. 03-40977.

CourtUnited States Courts of Appeals. United States Court of Appeals (2nd Circuit)
Citation406 F.3d 179
Docket NumberDocket No. 03-40977.
PartiesEdward John MCCARTHY, Petitioner, v. SECURITIES AND EXCHANGE COMMISSION, Respondent.
Decision Date26 April 2005

George Brunelle, New York, New York (Suzanne E. Auletta, Brunelle & Hadjikow, P.C., New York, New York, of counsel), for Petitioner.

Michael A. Conley, Washington, D.C. (Giovanni P. Prezioso, Eric Summergrad, Mark Pennington, Meyer Eisenberg, Securities

and Exchange Commission, Washington, D.C., of counsel), for Respondent.

Before: CARDAMONE, POOLER, and WESLEY, Circuit Judges.

CARDAMONE, Circuit Judge.

Congress passed the Securities Exchange Act of 1934(Act) so that investors might have confidence in the integrity of floor traders operating on the New York Stock Exchange (N.Y.SE or Stock Exchange), who by virtue of their position enjoy advantages that the investing public does not. This appeal brings before us a conviction against a floor broker for violating various provisions of the Act and its related regulations. Insofar as the broker's petition challenges his conviction, the petition is denied. But the two-year suspension upheld by the Securities and Exchange Commission (SEC or Commission), although a matter within the SEC's discretion, presents a case where the Commission gave no meaningful reasons in support of its decision. With respect to the suspension imposed, therefore, the petition is granted, and the SEC's affirmance of that portion of the sanction is vacated and the case remanded to the Commission for further proceedings consistent with this opinion. In all other respects, the petition is denied.

Edward John McCarthy (petitioner or appellant) petitions from the September 26, 2003 order of the Securities and Exchange Commission upholding the New York Stock Exchange Board's (Board) determination that he was guilty of numerous violations of the Securities Exchange Act of 1934 and related brokerage rules. McCarthy contends that the SEC's decision is not supported by substantial evidence and violates his right to due process. He also challenges the penalty of a two-year suspension, imposed by the Stock Exchange Board and affirmed by the SEC, on the ground that the penalty is inappropriately punitive under the circumstances of his case. McCarthy petitions this Court to reverse the Commission's determination of his guilt and vacate the two-year suspension imposed upon him.

For the reasons set forth below, we conclude that McCarthy's evidentiary and due process claims are procedurally barred, hence his petition challenging the Commission's decision finding him guilty of violating the Securities Exchange Act is denied. Insofar as the petition challenges the Commission's decision to uphold McCarthy's two-year suspension imposed by the Stock Exchange Board, we grant the petition and remand this case to the Commission for further proceedings consistent with this opinion.

A. The Oakford Trades

The facts presented by this petition bring before us another chapter in the criminal and regulatory prosecution of those involved in the so-called "Oakford scandal" in the 1990s. The Oakford Corporation (Oakford) was a Manhattan-based securities trading company that conspired with several floor traders at the NYSE by giving the brokers a beneficial interest in the Oakford account—that is, a share of net profits from trades made in the account—in return for which the brokers used their investment discretion for Oakford's benefit. See United States v. Oakford Corp., 79 F.Supp.2d 357, 358-59 (S.D.N.Y.1999). Several Oakford principals and brokers were found criminally liable for their role in the scheme. See id. In this case, we are concerned with an actor whose role in the scheme was of a relatively minor nature.

We recite briefly the relevant facts. McCarthy is an independent broker trading on the floor of the Stock Exchange. In June 1995, 16 months after he began operating as an independent broker, and at that time age 31, he began executing trades for Oakford. Petitioner consistently billed Oakford for his brokerage services in an amount equal to 70 percent of the net profits of these trades, and Oakford consistently paid him close to that amount. When Oakford began paying McCarthy less than 70 percent—as a result of previously undisclosed clearing fees that Oakford deducted from McCarthy's fee prior to payment—McCarthy called one of Oakford's principals, Bill Killeen, and asked why the payment was less than what McCarthy thought he was entitled to. Following this, at Killeen's instruction, McCarthy billed Oakford for an amount equal to the total net profit on his trades. The actual amount Oakford paid him continued to be about 70 percent of the net profit. Oakford was not billed for trades that resulted in a net loss.

Some of the particulars of McCarthy's trading transgressions are as follows. Of the 21 days of trading records contained in the record on appeal, there is evidence that on four occasions petitioner executed trades without objection from Oakford even though the trades were not authorized by Oakford. This conduct indicates that McCarthy exercised his own discretion when trading for the Oakford account. On numerous occasions McCarthy benefitted Oakford by "crossing trades"—that is, he executed another customer's order by buying or selling securities from the Oakford account for Oakford's benefit—and "trading ahead"—that is, McCarthy held orders for Oakford and another customer for the same stock and fulfilled the Oakford order first to allow Oakford to reap the benefit of the increase in price caused by the subsequent execution of the other customer's order.

Petitioner also failed to keep adequate records, especially by not time-stamping some order tickets and, on seven occasions, time-stamping the order tickets after the trades had been placed, suggesting that he may have executed the trades before receiving the orders to make such trades. McCarthy's records also lacked certain information on the Oakford account required by federal securities law and NYSE rules, such as the number of shares traded, the price of those shares, and whether the transfers were purchases or sales. Although petitioner employed a clerk to prepare bills for his other clients, he prepared the Oakford bills himself. He stopped handling trades for Oakford in March 1996, after performing that service for nine months.

B. Proceedings Below

On June 30, 2000 the Stock Exchange's Division of Enforcement brought charges against petitioner alleging that he had violated the following statutes and regulations governing the conduct of brokers: (1) Section 11a(1) of the Securities Exchange Act of 1934, 15 U.S.C. § 78k(a)(1) (1994), SEC Rule 11a-1(a) (codified at 17 C.F.R. § 240.11a-1(a)), and NYSE Rule 95(a), which collectively prohibit trading on an account in which a broker has an impermissible interest, or on an account over which the broker exercises investment discretion; (2) SEC Rules 17a-3 and 17a-4 (codified at 17 C.F.R. §§ 240.17a-3 and 240.17a-4) and NYSE Rules 123 and 440, which require brokers to make and preserve certain records; and (3) NYSE Rules 91 and 92, which prohibit a broker from "crossing trades" and "trading ahead," respectively.

Specifically, the Enforcement Division alleged that McCarthy: (1) had an impermissible interest in the Oakford account because he was paid a percentage of the net profits; (2) engaged in discretionary trading by placing orders without Oakford's consent and placing orders before time-stamping an order ticket; (3) crossed trades and traded ahead for Oakford's benefit; and (4) violated Stock Exchange record keeping requirements by failing to time-stamp several of his Oakford trades and neglecting to record and preserve other necessary information.

A Stock Exchange Hearing Panel took testimony in the matter and issued a decision on September 10, 2001 finding McCarthy not guilty on all charges filed against him, except those charging him with failing to keep proper records. In re Edward John McCarthy, Decision 01-106, 2001 WL 34056013, at *4-*5 (N.Y.S.E. Hearing Panel Sept. 10, 2001). The Hearing Panel concluded that the Enforcement Division had failed to sustain its burden of proof with respect to the charges of discretionary trading and trading on an account in which McCarthy had an interest. Id. at *4. It was of the view that McCarthy was an inexperienced floor broker who "simply received whatever his clients were willing to pay for his services," not realizing that his compensation was directly linked to net profits. Id.

The Hearing Panel also concluded that the meaning of having an impermissible "interest" in an account was unclear at the time of the violations. On October 6, 1998 the Stock Exchange, prompted by an August 21, 1998 letter from SEC Director of Market Regulation Richard Lindsey, issued NYSE Information Memo 98-34, stating that an impermissible "interest" for purposes of Rule 11a-1(a) was "any compensation arrangement that results in the member's sharing in the trading profits or trading losses of a customer's account, however structured and regardless of the extent of sharing in such profits or losses." The Hearing Panel determined that at the time McCarthy was trading for Oakford in 1995-96 it was generally understood by members of the Stock Exchange that simply being paid more by a customer based on greater profitability of trades, absent an express agreement to do so or some kind of ownership interest in the account, was not prohibited under Rule 11a-1(a). Id. at *3-*4.

The Hearing Panel further held there was insufficient evidence to conclude that McCarthy had engaged in discretionary trading, especially since there were other possible explanations for his behavior, including inadequate record keeping. Id. at *4. It therefore found petitioner guilty only of record keeping violations, censured him, and...

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