Disciplinary Proceeding - finra

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.NASD OFFICE OF HEARING OFFICERSDEPARTMENT OF ENFORCEMENT,Complainant,v.Respondent.<strong>Disciplinary</strong> <strong>Proceeding</strong>No. CAF030014Hearing Officer—Andrew H. PerkinsEXTENDED HEARING PANELDECISIONMarch 3, 2006Member firm found not liable for: (1) engaging in profit sharing, in violationof NASD Conduct Rules 2330(f) and 2110; (2) failing to file information anddocuments with NASD’s Corporate Finance Department, in violation ofNASD Conduct Rules 2710 and 2110; (3) failing to maintain accurate booksand records, in violation of Section 17(a) of the Securities Exchange Act of1934, Exchange Act Rule 17a-3, and NASD Conduct Rules 3110 and 2110;and (4) failing to maintain and enforce adequate supervisory procedures andfailing to supervise its brokers, in violation of NASD Conduct Rules 3010 and2110. Complaint dismissed.AppearancesFor the Complainant: David R. Sonnenberg, Lane A. Thurgood, and Jeffrey P.Bloom, NASD, Department of Enforcement, Washington, DC.For the Respondent: Theodore N. Mirvis, Allan A. Martin, David Gruenstein, andGeorge T. Conway, III, WACHTELL, LIPTON, ROSEN & KATZ, New York, NY.

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Table of ContentsI. INTRODUCTION ........................................................................................................................ 5II. PROCEDURAL HISTORY............................................................................................................ 6III. FACTS ...................................................................................................................................... 8A. Background......................................................................................................................... 81. Industry Commission Rates ............................................................................................ 92. Industry IPO Allocation Practices ................................................................................ 13B. The Firm............................................................................................................................ 19C. The Investigation .............................................................................................................. 21D. Enforcement’s Post-Complaint Development of its Profit-Sharing Theory..................... 28E. The Alleged Profit-Sharing Payments .............................................................................. 301. Non-Economic Cross or Wash Trades.......................................................................... 312. IPO Flips ....................................................................................................................... 33F. No Customer Evidence of Profit Sharing ......................................................................... 351. April 2002 Telephone Interviews ................................................................................. 352. Customer Statements and Memoranda ......................................................................... 363. Customer Affidavits...................................................................................................... 384. Customer Counsel Letters............................................................................................. 385. Hearing Testimony........................................................................................................ 386. On-The-Record Interview Testimony........................................................................... 39G. Statistical Evidence of Profit Sharing............................................................................... 421. Overview....................................................................................................................... 422. Enforcement’s Statistical Evidence—the Ferri-27 ....................................................... 44(a) Frequency of Inflated Rate Commissions............................................................. 44(b) Higher Total Gross Commissions......................................................................... 45(c) Correlation of Total Agency Commissions and Hypothetical Profits .................. 462

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.3. The Firm’s Statistical Evidence.................................................................................... 47(a) Profit Sharers were not Favored ........................................................................... 47(b) No Consistent Ratio of Commissions to Hypothetical Profits ............................. 53(c) Rates above Six Cents per Share were not Uncommon........................................ 564. Enforcement’s Statistical Evidence Lacks Probative Value......................................... 585. Conclusion Regarding Statistical Evidence.................................................................. 64H. The Firm’s IPO Allocation Practices................................................................................ 65I. The Firm’s Supervisory System........................................................................................ 661. The Firm’s Supervisory Structure................................................................................. 672. The Firm’s Supervision of Commissions ..................................................................... 683. The Firm’s Supervision of IPO Allocations ................................................................. 70IV. CONCLUSIONS OF LAW........................................................................................................... 71A. Profit-Sharing Charge ....................................................................................................... 711. Conduct Rule 2330(f) ................................................................................................... 71(a) Sharing Element.................................................................................................... 72(b) Profit Element ....................................................................................................... 752. Post-Conduct Settlements ............................................................................................. 78B. Ethics Charge.................................................................................................................... 791. NASD Conduct Rule 2110............................................................................................ 802. Expert Testimony.......................................................................................................... 82(a) Commercial Bribery Analogy............................................................................... 83(b) Customer–Client Dichotomy ................................................................................ 84C. Corporate Finance Charge ................................................................................................ 881. NASD Conduct Rule 2710............................................................................................ 892. Expert Testimony.......................................................................................................... 91D. Books and Records Charge............................................................................................... 92E. Supervision Charges ......................................................................................................... 941. Conduct Rule 3010 ....................................................................................................... 942. Failure to Supervise Charge.......................................................................................... 963

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.F. Inadequate Supervisory System and Written Procedures Charge .................................... 99V. ORDER ................................................................................................................................. 1004

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.DECISIONI. INTRODUCTIONThe Department of Enforcement (“Enforcement”) brought this proceeding against________________________ (“Respondent” or the “Firm”), an NASD member firm, allegingthat between October 1, 1999, and March 31, 2000, the Firm engaged in profit sharing byaccepting higher-than-normal commission rates from customers seeking allocations of initialpublic offerings (“IPOs”).The Complaint contains six causes of action. The first cause of action, as supplementedby the Bill of Particulars, 1 alleges that the Firm violated NASD’s profit-sharing rule (ConductRule 2330(f)) 2 when, on agency trades of listed securities, and in the absence of any profitsharingagreement or quid pro quo, the Firm accepted customer-set commission rates that werehigher than the normal industry rates paid by institutional customers. Enforcement refers to thesecommissions as “inflated rate commission payments” and alleges that the limited services theFirm provided to its customers did not justify the payments. In addition, although not an elementof the profit-sharing charge, Enforcement alleges that customers made the inflated ratecommission payments in order to gain access to “hot” IPOs. 3In large measure, the remaining five causes of the Complaint spring from the first. Thesecond cause of action alleges that the Firm improperly received inflated rate commission1 Bill of Particulars (Oct. 15, 2003).2 The Complaint further alleges that the Firm thereby violated Conduct Rule 2110, which provides that “[a]member, in the conduct of his business, shall observe high standards of commercial honor and just and equitableprinciples of trade.”3 An IPO is a corporation’s first offering of stock to the public. A hot IPO or hot issue is one in which the stockimmediately trades at a premium in the aftermarket because there is greater public demand for the stock than thereare available shares.5

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.payments and permitted its customers to try and influence the Firm to allocate them IPO shares,in violation of NASD Conduct Rule 2110. The third cause of action alleges that the Firmviolated NASD’s corporate finance rules, NASD Conduct Rules 2710(b)(1) and 2710(5)(a)(ii),and NASD Conduct Rule 2110, by failing to file information with NASD that disclosed theFirm’s profit sharing in its customers’ accounts. The fourth cause of action alleges that the Firmfailed to maintain accurate books and records that reflected the shared customers’ profits, inviolation of NASD Conduct Rules 3110 and 2110, Section 17(a) of the Securities Exchange Actof 1934 (“Exchange Act”), and Exchange Act Rule 17a-3. The fifth cause of action alleges thatthe Firm failed to supervise its registered representatives, in violation of NASD Conduct Rules3010(a) and 2110. The Complaint charges that the Firm’s supervisors failed to follow up onnumerous “red flags” of improper profit sharing. The final cause of action alleges that the Firmfailed to establish, maintain, and enforce an adequate supervisory system and written supervisoryprocedures that were reasonably designed to achieve compliance with applicable federalsecurities laws and NASD rules. Specifically, the Complaint charges that the Firm’s supervisoryprocedures provided insufficient standards regarding allocation of IPO shares, the receipt ofcommissions, and the supervision of Firm employees who allocated IPO shares, and the Firmthereby violated NASD Conduct Rules 3010(a), 3010(b), and 2110.II.PROCEDURAL HISTORYThe Department filed the Complaint on April 15, 2003. The Firm filed its Answer onMay 23, 2003, and denied any wrongdoing. In addition, the Firm raised 12 affirmative defenses.On September 16, 2003, the Firm filed a Motion for Summary Disposition, whichEnforcement opposed on October 24, 2003. The Firm’s motion sought dismissal of theComplaint on two of its affirmative defenses. First, the Firm argued that Enforcement’s profit-6

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.sharing theory is invalid because it amounts to a rule change that NASD did not submit to theSecurities and Exchange Commission (“SEC”), as required by Section 19(b) of the ExchangeAct. Second, the Firm argued that the Complaint must be dismissed because Enforcement hadconducted its investigation in a manner that violated basic tenets of investigative fairness andNASD’s obligation under Section 15A of the Exchange Act to provide a fair procedure fordisciplining members. The full Extended Hearing Panel (“Panel”) heard oral argument on theFirm’s motion on January 14, 2004, in Washington, DC. The Panel denied the motion by Orderdated March 18, 2004. 4Between January 19, 2005, and February 24, 2005, a 17-day hearing was held in NewYork City. 5 The Panel included the Hearing Officer, a former member of NASD’s Board ofGovernors, and a former member of NASD’s District 10 Committee. Enforcement presented 12witnesses and introduced 37 exhibits. The Firm presented 14 witnesses and introduced 172exhibits. In addition, the Parties introduced 15 joint exhibits. 6 The transcript of the hearingcontains more than 4,600 pages.Both Parties relied heavily on expert opinion testimony. In total, the Panel heard from 17experts. The Panel considered all of the opinion evidence, which diverged significantly oncrucial points. However, the Panel did not accept the experts’ opinions where they strayed into4 In light of the Panel’s findings in this Decision, the Panel did not address the Firm’s remaining affirmativedefenses.5 The hearing was postponed twice. The original hearing was scheduled for February 2004; however, the Partiesrequested that it be postponed to give the Panel ample time to consider the Firm’s Motion for Summary Disposition.The Hearing Officer rescheduled the hearing to November 2004. Enforcement later moved to adjourn the hearingagain because two members of its defense team were scheduled to participate in another hearing that conflicted withthe schedule in this case. Accordingly, the Hearing Officer rescheduled the hearing with the Parties’ agreement toJanuary 19, 2005.6 The hearing transcript is cited as “Tr.,” followed by the page number, the line number, and the witness’s name.Enforcement’s exhibits are referred to as “CX,” Respondent’s are referred to as “RX,” and the joint exhibits arereferred to as “JX.”7

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.those areas reserved exclusively for the Panel’s determination. For example, several expertstestified directly or tangentially on conclusions of law. The Panel did not give weight to suchtestimony in reaching its decision. 7Following the hearing, the Parties submitted post-hearing briefs. Enforcement filed itsbrief on May 16, 2005, and the Firm filed its brief on June 27, 2005. The Panel then heardclosing arguments in Washington, DC, on July 27, 2005.In summary, the Panel concluded that Enforcement failed to prove that the Firm shared inthe profits of its customers’ accounts or engaged in other conduct that contravened highstandards of commercial honor or just and equitable principles of trade. Accordingly, the Paneldismissed the primary charges in the Complaint. In addition, the Panel dismissed the remainingcharges. To the extent that the remaining charges were not dependent on a finding that the Firmhad engaged in profit sharing in violation of Conduct Rule 2330(f), the Panel concluded thatEnforcement had not proven them by a preponderance of the evidence.III.FACTSA. BackgroundA considerable amount of testimony centered on two issues: (1) the customary level ofcommission rates institutional customers paid on agency trades of listed securities; and (2) the7 See, e.g., Snap-Drape, Inc. v. Commissioner, 98 F.3d 194, 198 (5th Cir. 1996) (Tax Court properly declined toadmit expert witness reports offered by taxpayer that “improperly contain[ed] legal conclusions and statements ofmere advocacy”); United States v. Scop, 846 F.2d 135, 138–40 (2d Cir. 1988), modified, 856 F.2d 5 (2d Cir. 1988)(“repeated statements [by expert] embodying legal conclusions exceeded the permissible scope of opiniontestimony”); In the Matter of Potts, 53 S.E.C. 187, 1997 SEC LEXIS 2005, at *45 (1997) (ALJ properly excludedtestimony of law professor and former SEC commissioner that would have consisted of “mere opinion of law” and“would not [have] provide[d] evidence”); Department of Enforcement v. Fiero, No. CAF980002, 2002 NASDDiscip. LEXIS 16, at *91 (N.A.C. Oct. 28, 2002) (“the lawyers for the parties, not expert witnesses, ha[ve] the taskof arguing to the Hearing Panel what the applicable legal standards [are]”).8

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.methods used by brokers to allocate IPO shares to their customers. In each case, Enforcementargued that the Firm’s practices materially deviated from accepted industry norms and violatedapplicable NASD conduct rules. Accordingly, the Panel first considered these underlying issues.1. Industry Commission RatesFixed commissions were eliminated in 1975. 8 Since then, institutional customersgenerally have set the rates they pay, which was true during the relevant period. 9The Parties agreed that commission rates paid by the largest institutional customers foragency trades of listed securities generally fell within the four to seven cents per share levelduring the relevant period, depending on the nature of the transaction and services rendered.Three of Enforcement’s experts addressed this issue. Enforcement’s key expert on commissionrates, J. Patrick Campbell (“Campbell”), 10 stated in his report that the typical rate wasapproximately six cents per share for both large and small institutional accounts. 11 Dennis A.Green (“Green”) 12 stated that the generally accepted institutional rate at the time was between8 JX 14 49 (Joint Stipulations).9 Id. 38.10 Campbell has a wealth of expertise regarding the securities industry and financial market structure, which heobtained from his more than 30 years experience in the industry. Campbell spent the first 26 years of his career withThe Ohio Company, a privately held investment-banking firm. Campbell sat on The Ohio Company’s Board ofDirectors from 1991 until 1996, during which time he oversaw most of the company’s institutional and retailtrading. At the time of the hearing, Campbell was acting Chief Operating Officer of the American Stock Exchange.He served in numerous industry roles with, among others, the Securities Industry Association and NASDAQ. Inaddition, Campbell held a number of leadership positions at NASDAQ, including Chief Operating Officer and a asmember of its Board of Directors. He retired from NASDAQ at the end of 2001 as the President of NASDAQ USMarkets. CX 32 (Campbell report).11 CX 32 at 6 (Campbell report).12 Dennis A. Green is a securities industry consultant. He worked as a trader and supervisor at NASD member firmsfor more than 38 years. In May 2002, he retired from Legg Mason where he held the position of Senior Vice-President, Manager of NASDAQ Equity Trading. CX 34 at 1-2 (Green report).9

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.five and seven cents per share, regardless of the size of the trade. 13 And Edward A. Raha(“Raha”) 14 stated that five to six cents per share was a “fair rate” at the time. 15Based on the foregoing, Enforcement argued that the prevailing fair rate during therelevant period was six cents per share for all institutional agency trades, irrespective of eitherthe customer’s or the trade’s size. Thus, Enforcement questioned any rate that exceeded six centsper share.The Panel found, however, that industry rates were far from uniform. In fact,Enforcement’s experts recognized that some customers paid less than three cents per share andothers paid substantially more than six cents per share. For example, Raha testified that rates aslow as two cents per share were common for simple executions. 16 And, at the high end,Enforcement acknowledged that other member firms received commission rates equivalent to therates at issue here: over 20 cents per share. 17The Firm’s experts testified that commission rates, particularly for smaller customers,were far from uniform and that many major broker-dealers accepted commissions far in excessof six cents per share. For example, the Firm presented evidence that Morgan Stanley DeanWitter (“Morgan Stanley”) maintained a commission formula that yielded rates as high as 7113 CX 34 at 4 (Green report).14 Edward A. Raha holds a Masters of Business Administration in finance from the University of Chicago GraduateSchool of Business. Raha has been employed as a broker and trader in the securities industry since 1983. Between1990 and 1994, he worked at Bankers Trust, managing the bank’s private equity portfolio, and at Donaldson, Lufkinand Jenrette, as a broker for high net worth individuals and large institutions. Currently, Raha is employed byManaged Quantitative Advisors, a registered investment advisor/hedge fund. CX 36 at 2-4 (Raha report).15 CX 36 at 3 (Raha report).16 Tr. 2109:15-18 (Raha).17 JX 14 39 (Joint Stipulations).10

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.cents per share on trades of 10,000 shares at $100 per share. 18 Enforcement did not present anyevidence disputing these facts. To the contrary, Raha, one of Enforcement’s commission experts,testified that his former firm, Donaldson, Lufkin and Jenrette, maintained a rate card 19 thatreflected rates as high as 27, 35, 42, and 49 cents per share for 10,000-share trades at share pricesof $25, $50, $75, and $100 respectively per share. 20 Green, another Enforcement expert, similarlyadmitted that many firms maintained rate schedules that permitted brokers to acceptcommissions at rates exceeding 20 cents per share. 21 Indeed, Green testified that his former firm,Legg Mason, maintained rate schedules with rates “way more than six cents per share.” 22Nevertheless, Enforcement argued that Green and Raha supported its position that ratesin excess of six or seven cents per share were excessive for institutional customers. The Panel,however, rejected their opinions because they based their conclusions on non-comparable data.Green and Raha referenced data concerning institutions many times the size of the customerswho paid the “inflated rate commissions” to the Firm. 23 Green based his opinion on his personalexperience with customers at Legg Mason that had assets in excess of $10 million, while manyof the Firm’s customers were much smaller. 24 Moreover, Green did not conduct a survey ofcommission rates to verify his conclusions. 25 Raha on the other hand testified about the rates paid18 RX 234; RX 238.19 RX 230.20 See RX 239 at 10534 (calculations based on RX 230).21 Tr. 1182:24-1183:13 (Green).22 Tr. 1185:12-14 (Green).23 Green formulated his opinion without any information about the size of the Firm’s customers. Tr. 1131:4-9,1193:18–24 (Green).24 Tr. 1162:8-12, 1163:2-8 (Green).25 Tr. 1185:17-1186:14 (Green).11

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.by investment advisors, although none of the Firm’s customers were investment advisors, 26 andhis knowledge of commission rates was based on his experience as someone who managedapproximately $100 million in client assets, and traded approximately 200 million sharesannually. 27 Significantly, 200 million shares annually is approximately five times the totalnumber of shares traded by all 35 customers at issue in this case during the relevant period. 28Finally, both Green and Raha relied on industry data derived from surveys of institutionalcustomers far larger than any of the Firm’s. For example, Green relied on a New York Timesarticle 29 that cited to a report prepared by the Plexus Group, a company that studies commissionsfor buy-side firms . 30 However, Green was not aware that the Plexus report was based on tradedata from 125 clients that managed $4.5 trillion in equities, which meant that the average clientmanaged $36 billion in assets and traded hundreds of millions of shares per quarter. 31 Raha reliedon Plexus data as well as data from another firm called Abel/Noser, which similarly was basedon firms that traded billions of dollars annually. 32 The Firm’s customers were dwarfed incomparison. For example, 20 of the customers who paid inflated rate commissions had a netequity of less than $5 million each. 33 Enforcement’s experts did not study separately the practicesof such smaller firms to confirm their general conclusions regarding “institutional rates.”26 Tr. 2163:15-21 (Raha was asked to render opinion “on the commissions and commission rates small to mediumsizedinvestment advisor[s] would be expected to pay”).27 Tr. 2122:5-7, 2125:17-25, 2126:12-14 (Raha).28 See RX 312; Tr. 2127:14-20 (Raha).29 See Tr. 1187:7–1188:7, 1188:24–1189:5; CX 34 at 5 (Green report).30 Tr. 1187:15-20, 1190:21–1191:8 (Green).31 Tr. 1192:3-1193:17, 1194:13-1195:18 (Green).32 Tr. 2169:14-16, 2169:25–2170:9, 2170:15-2171:2, 2171:12–2173:2 (Raha); CX 36 at 18, 22 (Raha report).33 RX 247 at 10636-37.12

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.The Panel concluded that while six cents per share was a very common rate paid by largeinstitutions, it was not the universal standard for smaller “institutional” customers. Indeed, theevidence shows that larger institutions with greater volume to give brokers often paid less thansix cents per share, while smaller institutional customers paid substantially higher rates in orderto obtain services and maintain a favorable relationship with their brokers. Moreover, memberfirms did not prohibit the acceptance of commission rates above 20 cents per share where thecustomer set the rate without being pressured to do so by its broker. Accordingly, the Panel didnot consider the magnitude of the commission rates by itself to evidence profit sharing or otherwrongful conduct.2. Industry IPO Allocation PracticesThe industry-wide practice is to allocate IPO shares to broker-dealers’ best customersmeasured by their aggregate commissions. This method has been accepted industry practice forat least the last 30 years. 34 All of the experts who testified on this point agreed. For example,Edwin R. Olsen, 35 who was involved in more than 1,000 underwritings during his career,testified on behalf of the Firm that he knew of no other way to allocate IPO shares. 36 Indeed,Olsen explained that the firms for which he worked gave very specific instructions on how toallocate IPOs based on commission business. They directed him to ensure that he allocated thefirms’ resources “to the firm’s largest accounts as measured by gross aggregate commissions orthe revenue and the value … those institutions brought to the firms .…” 37 The Firm’s experts34 Tr. 3159:11–3160:13 (Olsen).35 Edwin R. Olsen has more than 30 years experience in the securities industry, 25 of which involved responsibilityfor managing the allocation of shares in IPO and secondary offerings. Most recently, Olsen was employed by J.P.Morgan Chase as Managing Director of Equity Capital Markets. Olsen retired from J.P. Morgan Chase in February2002. RX 8 at 1003-1005 (Olsen report).36 Tr. 3163:9-13 (Olsen).37 Tr. 3152:3-13 (Olsen).13

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Dan W. Lufkin (“Lufkin”) 38 and Professor John C. Coffee, Jr. (“Coffee”) 39 agreed. Lufkintestified that it was “the common practice of firms to allocate shares to best or good customersbased on their commission business.” 40 According to Coffee, “the basic rule was—within thisindustry—that aggregate commissions were going to be the principal criterion upon which IPOshares were allocated when there was an oversubscribed or hot IPO.” 41 In addition, StanleyShopkorn (“Shopkorn”), 42 another Firm expert, testified to this practice. 43 Indeed, Enforcementstipulated that it was a common practice during the review period for firms to take commissionbusiness into account in making IPO allocations. 44Enforcement further stipulated that an underwriter lawfully may exercise discretion inIPO allocations, and may allocate IPO shares to customers as it chooses, unless such an38 Dan W. Lufkin is the founder and former Chairman of Donaldson, Lufkin & Jenrette, Inc. He is a graduate ofHarvard Business School, and he served as a Governor of the NYSE. RX 6 at 848, 851 (Lufkin report).39 Professor John C. Coffee, Jr., holds a law degree from Yale University and is the Adolf A. Berle Professor ofLaw at Columbia University Law School, specializing in corporate and securities law. Coffee has served on theLegal Advisory Board of NASD and on the Legal Advisory Committee to the Board of the NYSE. RX 2 at 78-79(Coffee report).40 Tr. 3657:9-13; accord RX 6 at 851-52 (Lufkin report).41 Tr. 4287:2-6; RX 2 at 92, 106 (Coffee report) (citing, in part, remarks of former SEC Chairman Arthur Levittsupporting the practice of allocating hot IPOs to brokers’ best customers as measured by their aggregate level ofcommission business and acknowledging that shares are often allocated according to business relationships andother subjective criteria) (citations omitted).42 Stanley Shopkorn runs Shopkorn Management LLC, an investment firm with seven securities professionals.Shopkorn has over 35 years of experience as a securities industry professional. From 1973 to 1991, he was withSalomon Brothers. In 1978, he became a general partner of Salomon Brothers and eventually served as its ViceChairman and as a member of its Executive Committee. Following his tenure at Salomon Brothers, Shopkorn wasthe Chairman of Ethos Capital, a hedge fund that merged into Moore Capital in 1996. He then managed all ofMoore Capital’s equity activities, including the purchase of underwritings. RX 10 at 1958-59 (Shopkorn report).43 Tr. 3357:25–3358:8 (Shopkorn); accord RX 10 at 1954 (Shopkorn report).44 JX 14 37 (Joint Stipulations).14

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.allocation constitutes spinning, 45 an unlawful quid pro quo, or other prohibited conduct. 46 Suchlawful discretion includes allocating IPO shares to an underwriter’s best customers measured byaggregate commission business the customers did with the underwriter.The Panel further found that customers that desire IPO allocations have to compete forthem by the amount of non-IPO commission revenue they generate. 47 This is standard practicethroughout the securities industry. 48 For customers who are unable to do a substantial volume oftrades, this means they must find an alternate way to generate sufficient non-IPO commissionbusiness, or they are ineligible to receive IPO allocations. 49Several Firm customers confirmed this industry-wide practice. For example, TR, anindividual who managed about $1 million of “family money,” 50 testified at his on-the-recordinterview that he learned when he first entered the business that he had to establish himself as a“good client” to get IPO allocations and that broker-dealers determined their good clients by theamount of commission business they did. 51 He understood “good clients” to be regular traders45 Spinning is the practice whereby underwriters allocate hot IPO shares to executives of prospective investmentbanking clients in return for future investment banking business.46 JX 14 36 (Joint Stipulations).47 See, e.g., Tr. 376:15-24 (Ozag).48 See, e.g., Tr. 1754:18-20, 1694:22-25 (Campbell); Tr. 2161:22-2162:2 (Raha) (it was “standard practice to look ataggregate commissions and potential for aggregate commissions in allocating IPOs”); Tr. 2493:11-13; accord Tr.2448:8-11 (Bogle) (acknowledging “common practice in the industry to take commission business into account ingiving out IPOs”).49 See, e.g., RX 1 at 23 (Antolini report) (professional investors pay commissions “to maximize their aggregateamount of commission business in order to be considered one of an underwriter’s ‘best’ customers” so that they canreceive IPO allocations). Robert Antolini, one of the Firm’s experts, is one of the principals of Great South BayTrading LLC, a small-cap hedge fund. Before establishing Great South Bay in 1998, Antolini spent his nearly 40year career at several NASD member firms where he held various senior positions relating to the firms’ over-thecounteroperations. His experience involved his firms’ IPO allocation practices. RX 1 (Antolini report).50 Despite the relative small size of this account, the Firm treated it as an “institutional account.”51 RX 121 at 6440-41, 6495-97. Some large firms even had express policies that required at least 50% of theircustomers’ business come from non-syndicate trades. The Firm did not have such a policy.15

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.who generated commissions. 52 Thus, to be seen as a “good client,” TR concluded he had to tradefrequently and pay higher commission rates than would be necessary if he only wanted tradeexecutions. 53TR described his process of selecting a registered representative and becoming a goodclient as follows. First, TR identified firms and registered representatives at those firms whichhad access to IPOs. He would do this by observing the firms listed on the prospectuses hereceived and by reviewing IPO tombstone announcements carried in the Wall Street Journal andother financial publications. 54 Once he identified a broker-dealer that had access to IPOs, hecalled the firm to open an account. 55 TR testified that to his best recollection he made such a callto establish his account at the Firm. 56After TR identified a firm and broker, he would open an account and commence doing alimited amount of business with the broker to evaluate whether the broker was one of the betterproducers of IPO shares at the firm. 57 TR referred to this as a “feeling out period,” during whichhe would do a minimal amount of business with the new broker. If TR was pleased with theallocations he received, he increased the amount of business he did with the broker. 58If a broker proved he had good access to IPOs, TR’s next step was to attempt to increasethe size of his allocations. TR did so by doing more volume and by increasing the cents-per-52 RX 121 at 6446.53 Id.54 RX 121 at 6442.55 Id.56 Id.57 RX 121 at 6495-96.58 RX 121 at 6496.16

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.share rates he paid. The object was to become a better client. TR viewed this process as acompetition with the brokers’ other customers who also were interested in purchasing IPOshares. 59 The process proved difficult because it operated as a “blind draw.” TR did not learnwhere he stood until the morning an IPO came out. 60 Only then would he know how he stoodwith the broker. If TR got a good allocation, he knew that the level of business he was doingwith that broker was sufficient. If not, he knew he had to increase the level of commissionrevenue he did with the broker. 61TR’s sole reason to increase business with the Firm and other similar firms was toreceive greater IPO allocations. TR did not base the rate he paid on his profits. 62 Nor did he setcommissions as a percentage of his IPO profits. 63 TR pegged both his trading volume and hiscommission rates to the levels he considered necessary to obtain IPO allocations. He judgedthose levels through a trial and error process; he never discussed with any broker the amount heneeded to pay in order to become a “good client.” 64TR further explained that his limited capital meant that he had to engage in short-termtrading because he did not have enough capital to become a “good client” and hold investmentsfor the long term. Instead, TR relied on frequent trading to generate a valued level of business.59 RX 121 at 6449.60 Id.61 RX 121 at 6448.62 RX 121 at 6492-93.63 RX 121 at 6493.64 RX 121 at 6462.17

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Nonetheless, TR testified that he did not engage in trades only to benefit his broker. 65 To thecontrary, TR testified that he expected to make a profit on all of his trades. 66TR’s experience typifies that of other small “institutional” customers. In contrast, largeinstitutions use their superior economic advantage to obtain IPO allocations. For example,Fidelity Investments insists upon receiving at least twice the next-highest allocation in return forlarge order flow. 67 This policy is referred to in the industry as the “Fidelity Formula.” If a brokerdealerrefuses to comply, Fidelity puts it in the “penalty box” by pulling business from therecalcitrant firm. 68Enforcement’s experts testified that industry participants and regulators accepted thepractice of favoring such large institutions. For example, Campbell testified that he saw nothingwrong with a customer directing commission business to a broker-dealer to improve its standingas a good customer. 69 Even John C. Bogle, 70 Enforcement’s ethics expert, could only quibblewith the ethics of the Fidelity Formula before ultimately conceding that it was an acceptedpractice to favor those customers who directed commission business to a broker-dealer for thepurpose of influencing the IPO allocation process.65 RX 121 at 6458-59.66 Id.67 See, e.g., Tr. 2494:10-15.68 Tr. 3185:18–3188:15 (Olsen); 2494:20–2495:7 (Bogle).69 Tr. 1703:13–1704:7 (Campbell).70 John C. Bogle, founder of The Vanguard Group, has a long and distinguished career in the financial servicesindustry. He started his career in the field of financial markets in 1951 following his graduation from PrincetonUniversity, magna cum laude, with a degree in economics. He served for 30 years as Chief Executive Officer of twomutual fund firms—Wellington Management Company from 1967 until 1974, and The Vanguard Group from 1974until 1996. Among his numerous accomplishments, he has written four books and many articles about investing,financial markets, and mutual funds. CX 31 (Bogle report).18

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Enforcement’s witnesses expressed no concern over the fact that the largest institutions,such as Vanguard and Fidelity, often pay higher cents-per-share commission rates to brokerdealersfrom which they sought new issues. Every witness who addressed the topic readilyadmitted that large institutions could pay far less than six cents per share on trades of listedsecurities. Indeed, the largest customers have the economic power to push the rate below a pennya share. Nevertheless, they pay more where they seek other services, including IPO allocations.In so doing, the large institutions routinely reward broker-dealers with increased order flow andcommissions for generous IPO allocations.In conclusion, the Panel finds that there was keen competition for IPOs during the reviewperiod, which drove institutional customers to direct order flow—and pay increased commissionrates—to those broker-dealers that had a supply of IPOs. In both cases, customers voluntarily sethigher commission rates to increase their relative position as “good customers.” But in neitherscenario did this conduct alone amount to profit sharing.B. The FirmThe Firm is a small registered broker-dealer in New York City. 71 At no time has it hadmore than about 12 registered employees. 72 During the relevant period, the Firm had no morethan 100 active accounts at any one time (i.e., accounts that executed at least three trades permonth) and processed only about 40 to 50 agency trades per day. 73 Most of the Firm’s customerswere hedge funds and other institutional investors. 7471 JX 14 1, 3 (Joint Stipulations).72 JX 14 4 (Joint Stipulations).73 Tr. 1265–68, 1271 (LS).74 JX 14 5 (Joint Stipulations).19

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.KL founded the Firm in 1974, and he has headed the Firm since then. 75 During the sixmonthperiod in issue, October 1, 1999, to March 31, 2000, KL was the Firm’s Chief ExecutiveOfficer; CK was the Chief Operating Officer; JB was the Chief Compliance Officer and ChiefFinancial Officer; and LS was the head trader and sales supervisor. 76Commission business was a minor portion of the Firm’s revenue. The Firm earned mostof its revenue from its investments. 77 During the relevant period, the Firm derived 11.8% of itsgross revenue from commissions. 78 The Firm did not stress commission business, and most of itsorder flow was unsolicited. 79 JB testified that commission business was relatively unimportant toKL, who, JB believed, looked to commission revenue merely to cover the Firm’s overhead. 80The Firm actively participated in new offerings. Thanks to a close relationship withCredit Suisse First Boston (“CSFB”) forged in the 1980s, the Firm often was brought into thesyndicate or selling group in offerings lead-managed or co-lead-managed by CSFB. 81 Most of the57 IPOs in which the Firm participated during the relevant period were such offerings. 82 TheFirm’s allocations ranged from a low of 400 shares to a high of 300,000 shares. 83 In one-third ofthese IPOs, the Firm received 10,000 shares or fewer. 84 In a given IPO, the Firm’s four sales75 JX 14 4 (Joint Stipulations); Ans. 1.76 JX 14 4 (Joint Stipulations); Tr. 1241, 1244, 1452, 1569.77 Tr. 1566–67.78 RX 350.79 Tr. 1570:2-3 (JB).80 Tr. 1568:11-14 (JB).81 See Compl. 12.82 JX 14 7–8, 54–55 (Joint Stipulations).83 See CX 7 (All Review Period IPOs).84 Id.; see also Tr. 620 (Ozag).20

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.representatives got 30 to 35% of the Firm’s retention for allocation to customers. The rest of theretention was distributed among the Firm’s house accounts—accounts to which no broker wasassigned and to which IPO allocations were made by a supervisory principal. 85 The Firm’s IPOallocations were based upon, among other things, the aggregate amount of business the customerhad generated in the past, the customer’s potential to develop regular commission business, andthe customer’s expressed interest in becoming a holder of the shares. 86C. The InvestigationEnforcement opened the investigation that led to the filing of the Complaint in thisproceeding because it had been investigating CSFB’s IPO allocation practices. 87 The CSFBinvestigation originated out of a broader inquiry by NASD and the SEC into whether brokerdealershad taken advantage of customers during the “hot” IPO boom of the 1999–2000 period.Ultimately, the CSFB investigation focused on evidence that, in exchange for shares in hot IPOs,CSFB had wrongfully extracted from certain customers a percentage of the profits thosecustomers made by flipping 88 their IPO stock. The SEC alleged that CSFB forced customers tocomply by withholding IPO allocations from those customers who refused to make thedemanded payments. The SEC and NASD contended that CSFB’s extraction of payments fromits customers amounted to impermissible profit sharing, in violation of NASD Conduct Rule85 JX 14 59, 77 (Joint Stipulations); Ans. 18.86 JX 14 56 (Joint Stipulations).87 Tr. 174. These investigations were launched because of an anonymous tip letter received by NASD’s CorporateFinancing Department. Tr. at 2839:19-22 (Price).88 Flipping is the process of buying shares in an IPO and selling them immediately for a profit. A customer whoengages in this practice is called a flipper.21

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.2330. 89 Here, however, there is no allegation that the Firm or any of its brokers coerced anycustomer to pay commissions to the Firm in connection with IPO allocations.In order to analyze CSFB’s allocation practices, Joseph Ozag (“Ozag”), NASD’s leadinvestigator on both the CSFB and the Firm investigations, formulated a criterion to define thescope of the CSFB investigation. 90 Ozag determined that he would limit his inquiry totransactions of 20 cents per share or more on trades of 10,000 shares or more.Ozag developed the 20-cent, 10,000-share metric in two steps. First, at the start of theCSFB investigation, Ozag and other NASD staff determined that they wanted to examine“institutional” size trades. Ozag understood that trades of 10,000 shares had to be reported as ablock trade, so he defined “institutional trades” as trades of 10,000 shares or more. 91Enforcement adopted Ozag’s definition as the CSFB investigation progressed, and Enforcementused the same definition in this case. 92Ozag developed the second criterion based on his discussions with the head of EquitySales Trading at CSFB. 93 During the on-site investigation at CSFB, Ozag interviewed a numberof employees selected by CSFB to better understand the nature of CSFB’s business andoperations. One of those employees was Tony Ehinger (“Ehinger”), the head of CSFB’s EquitySales Trading. Ozag asked Ehinger if there was a standard or normal commission in the industryfor 10,000-share trades done on an agency basis in listed securities. Ehinger replied that he could89 CX 50. The SEC alleged that the cooperating customers channeled payments to CSFB in the form of excessivebrokerage commissions generated in unrelated securities trades that the customers effected solely to share their IPOprofits with CSFB. In January 2002, CSFB settled all charges related to its IPO allocation practices.90 Tr. at 320:10-17 (Ozag).91 Tr. 313:10-15 (Ozag).92 Tr. 313:10-15 (Ozag).93 Tr. 326:5-25 (Ozag).22

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.not say that there was a standard commission, but commissions on such trades ranged from 6 to10 cents per share, with 6 cents being more the norm in the relevant period. 94 Ozag then doubledthe top end of the range and arrived at 20 cents per share—a value he considered well outside thenorm. In his opinion, such a commission would be “unusual or semi-unique.” 95When Ozag opened the [] investigation [of the Firm], he applied the same metric he haddeveloped for the CSFB investigation to define unusual, institutional-size trades. However,whereas Enforcement used the metric as a data management tool in the CSFB case, here,Enforcement used the metric to define profit sharing under Conduct Rule 2330(f).Ozag opened the [] investigation [of the Firm] because he noticed during the CSFBinvestigation that the Firm’s name often appeared as a member of either the syndicate or sellinggroup. 96 Ozag suspected that the Firm might have engaged in conduct similar to that charged inthe CSFB case. 97 Ozag limited his investigation to the Firm’s agency trades executed betweenOctober 1, 1999, and March 31, 2000, because this was a period of many hot IPOs. 98To test his suspicion that the Firm had accepted profit-sharing payments in the form ofhigher-than-normal commissions on agency trades, Ozag asked the Firm to provide trade data forall agency transactions of 10,000 shares or more where the commission equaled or exceeded 20cents per share. 99 In addition, on May 21, 2001, Ozag delivered a Rule 8210 request that the Firmprovide a broad range of documents relating to all equity IPOs the Firm participated in during94 Tr. 326:13-16 (Ozag).95 Tr. 326:21-25 (Ozag).96 Tr. 174:22-24, 187:7-10 (Ozag). CSFB led or co-led 85% of the IPOs Ozag reviewed. Tr. 188:2-3 (Ozag).97 See Tr. 183:2-5 (Ozag).98 Tr. 182:16–183:18. The Firm participated in more than 50 IPOs during the review period. JX 14 54 (JointStipulations).99 Tr. 183:6-10. Exhibit CX 9 lists the agency trades by customer.23

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.the review period and its IPO allocation policies and procedures. 100 The Firm produceddocuments responsive to Ozag’s Rule 8210 request during the on-site visit. 101 The Firm alsoproduced documents in response to supplemental Rule 8210 requests Enforcement made after itson-site visit. 102Ozag then “eyeballed” the data the Firm produced and concluded that it looked like manytrades with inflated rate commission payments had been executed on or about the days on whichthe Firm had participated in a hot IPO. 103 With his suspicion tentatively confirmed, Ozagproceeded to load the data he had collected into a computer program he developed for the CSFBinvestigation, which he called a Matched Transaction Analysis. 104The Matched Transaction Analysis was a computer query with two tables. The first heldthe agency trade data, and the second held the data related to the Firm’s IPO allocations. Theprogram compared the agency transactions completed on or within one business day of an IPOwith the Firm’s IPO allocations. 105 The purpose was to identify customers who paid inflated ratecommission payments of 20 cents or more on trades of 10,000 shares or more who also receivedIPO shares from the Firm. 106 From this analysis, Ozag found that all customers who paid aninflated rate commission received at least one hot IPO during the review period. 107 AlthoughOzag found no apparent difference in the allocations to customers who had not made inflated100 RX 102; JX 14 86 (Joint Stipulations).101 JX 14 87 (Joint Stipulations).102 Id. 88.103 Tr. 188:8-12 (Ozag). Exhibit CX 7 lists the IPOs the Firm sold during the review period.104 Tr. 188:12-16 (Ozag).105 Tr. 188:12–189:4, 199:16-20 (Ozag).106 Tr. 188:15–189:4 (Ozag).107 Tr. 191:20-22 (Ozag).24

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.rate commission payments within one day of an IPO, Enforcement concluded that the MatchedTransaction Analysis confirmed its tentative thesis that the Firm’s customers had made profitsharing payments to the Firm. 108Next, Enforcement took on-the-record testimony from 11 Firm employees—fourmanagers, four sales representatives, and three individuals on the Firm’s trading desk. 109 Inaddition, Enforcement informally interviewed three of the Firm’s customers regarding theircommission payments. 110 Enforcement had wanted to interview others, but many refused tocooperate. 111On April 9, 2002, Enforcement delivered a Wells notice to the Firm telephonically. 112 TheFirm submitted its initial Wells Submission on May 31, 2002, 113 and, on September 23, 2002,met with Enforcement to discuss the investigation. 114 Thereafter, between October 2002 andFebruary 2003, Enforcement interviewed an additional customer on an unsworn basis and tookthe on-the-record testimony of four other customers. 115 Each customer denied that he had enteredinto an agreement to share profits with the Firm or any of its registered representatives. 116108 See Tr. 455:3-7 (Ozag). Enforcement never analyzed whether there was a difference in the quantity of shares theFirm allocated customers depending on whether they made inflated rate commission payments.109 JX 14 90 (Joint Stipulations).110 See RX 106 (Enforcement’s interview notes).111 RX 111.112 JX 14 91 (Joint Stipulations).113 RX 107.114 JX 14 92 (Joint Stipulations).115 JX 14 94, 96 (Joint Stipulations). The Firm provided Enforcement with contact information for each of the 30customers Enforcement wanted to interview. RX 112; RX 113. In addition, the Firm encouraged its customers tocooperate with NASD’s investigation although Enforcement never requested the Firm’s assistance. Tr. 565:17-24(Ozag).116 Tr. 344:23–346:14; 350:5-18; 355:13–357:11; 368:25–369:3; 371:18-25; 547:7-17 (Ozag); RX 106 at 6199,6201, 6203, 6215, 6231–6233, and 6235; CX 38 at 68-69; RX 130 at 6754-55.25

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Ultimately, Enforcement reached the following conclusions regarding commissionpayments at the Firm, which are incorporated into the Joint Stipulations (JX 14) filed in thiscase:• “[The Firm]’s customers decided themselves what commission rate theywould pay.” (Joint Stipulation No. 41.)• The Firm never “urged or demanded that its customers pay a set amount orrange of commissions or pay commissions at ‘inflated’ rates.” (JointStipulation No. 42.)• The Firm never “told the customers at issue that they had to pay a setamount or range of commissions or pay commission at or above any centsper-sharerate in order to receive IPO allocations.” (Joint Stipulation No.43.)• “None of the customers inquired of [the Firm] what level of commissions(gross or cents-per-share) they would have to pay in order to receive IPOallocations.” (Joint Stipulation No. 44.)• “[The Firm]’s historical practices and procedures with regard to customercommissions and IPO (and secondary) allocations during the time periodcovered by the Complaint were the same as those in existence at the Firmsince the elimination of fixed commissions in 1975.” (Joint StipulationNo. 49.)These findings distinguish this case from the CSFB matter.26

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.In addition, Enforcement concluded that order flow from the customers Enforcementalleged made inflated rate commission payments was unsolicited, and was given directly to thetrading desk. 117 There is no evidence that any Firm broker ever requested or coerced anycustomer to pay higher commission rates to receive IPO allocations, or for any other reason.Nonetheless, Enforcement concluded that between October 1, 1999, and March 31, 2000, theFirm had engaged in widespread misconduct by accepting commissions paid by customers whowere sharing with the Firm a portion of their real or hypothetical profits derived from the hotIPOs they received from the Firm. 118 Enforcement further alleged that the same customers madesimilar payments to other broker-dealers and received hot IPOs from those firms. 119 TheComplaint provided examples of the trades Enforcement questioned but did not identify theentire list of trades involving inflated rate commissions.Ultimately, Enforcement charged that the Firm shared in the profits in its customers’accounts in three ways: (1) by accepting commissions of 20 cents per share or more on trades of10,000 shares or more; 120 (2) by accepting commissions from two customers who engaged incross or wash trading; 121 and (3) by accepting high commissions from at least two customers whoflipped their IPO shares through the Firm at a substantial profit. 122117 JX 14 64-65 (Joint Stipulations).118 Compl. 1, 21, 23.119 Id. 22.120 Id. 21.121 Id. 34. Although Enforcement refers to “wash trading,” none of the trades met the definition of a wash sale.“‘Wash’ sales are transactions involving no change in beneficial ownership.” Ernst & Ernst v. Hochfelder, 425 U.S.185, 206 n.25 (1976). NASD Marketplace Rule 6440(b)(1) prohibits wash trades where they are made to create orinduce a false or misleading appearance of activity in a security or to create or induce a false or misleadingappearance with respect to the market in such security. Here, all of the sales involved a bona fide change ofownership.122 Id. 31-33.27

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.D. Enforcement’s Post-Complaint Development of its Profit-Sharing TheorySeveral months after Enforcement filed the Complaint, Enforcement retained Campbellas an expert to review the commission rates paid by the Firm’s customers. 123 Campbell testifiedthat he looked at the transactions Enforcement identified and then suggested that Enforcementshould develop additional metrics “to identify if there was something that was out of thenorm.” 124 Campbell thought that Enforcement needed to employ finer increments to analyze thetrades in question. 125 He therefore proposed additional metrics, which Enforcement adoptedwithout reference to the Firm’s specific policies and practices. 126 Campbell arrived at hissuggested metrics by what made good economic sense to him. 127 They are:1. $.20 per share or more on agency trades of 10,000 shares or more;2. $.20 per share or more on non-economic cross trades 128 of 5,000 sharesor more;3. If the customer’s trading activity included trades meeting one of theabove criteria, DOE also viewed as profit-sharing trades, any trades at acommission of $.75 per share or more on trades of 1,000 shares or more;[and]4. $1 per share or more on “flips” of 200 shares or more that the Firmallocated to the customer. 129123 Tr. 1661:12-24; 1688:20-24 (Campbell).124 Tr. 1662:5-12 (Campbell).125 Tr. 1670:10-13 (Campbell).126 Tr. 1671:8-12; 1705:23–1707:25 (Campbell).127 Tr. 1671:13–1672:11 (Campbell).128 Enforcement defined “non-economic cross trades” as those where a customer bought and sold the same numberof shares of a security at or about the same price on the same day. Tr. 200:3-6 (Ozag). At other points, Enforcementrefers to the same category of trades as “non-economic wash trades.”129 Bill of Particulars at 2 (emphasis in the original).28

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Campbell saw the central issue as the problematic behavior of paying above-normalcommissions to get access to IPOs rather than profit sharing. Accordingly, he devised the metricsto identify the commission levels that made no economic sense unless the customer is assuredthat there will be an IPO allocation to justify the costs. 130 Thus, although the metrics defined“inflated rate commission payments,” the metrics rested on Campbell’s objection to customerscompeting for IPO allocations through increased commissions as opposed to increased orderflow. Campbell stopped short, however, of declaring all commissions within his metrics to beinherently excessive. Campbell recognized that sometimes a commission falling within themetrics could make economic sense. In his opinion, ultimately, whether or not a payment wasexcessive, and therefore constituted impermissible profit sharing, depended on what service thecustomer received in return for the higher-than-normal commission payment. 131 In that regard,Campbell testified that a customer could judge for itself the value of the services it receivedwithout conflicting with any conduct rules or regulations. 132Enforcement adopted Campbell’s suggestions. However, Enforcement determined thatthe Firm’s acceptance of any commission that fell within any of the enumerated criterionconstituted a per se violation of Conduct Rule 2330(f). That is, unlike Campbell, Enforcementdetermined that the commission levels evidenced profit sharing without regard to the Firm’s IPOallocation practices.130 Tr. 1681:25–1682:15 (Campbell).131 Tr. 1684:11-23 (Campbell).132 Tr. 1684:24–1685:5 (Campbell).29

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.E. The Alleged Profit-Sharing PaymentsEnforcement reviewed 9,621 agency trades placed by 1,364 customers at the Firmbetween October 1, 1999, and March 31, 2000. From this review, Enforcement determined that695 of the trades fell within the metrics it had formulated for this case and were, therefore,profit-sharing payments. Their classification as profit-sharing payments was not dependent upona finding that the Firm allocated IPO shares to the paying customers. Enforcement listed the 695trades on Amended Schedule A (“Schedule A-35”), 133 which Enforcement filed with its responseto [Respondent’s] Motion for a More Definite Statement. 134 The transactions sometimes arereferred to as the “Schedule A-35 trades.” 135The Firm earned total gross commissions of $4,133,013 on the Schedule A-35 trades,which equaled more than one-third of the Firm’s total agency commissions during the reviewperiod. 136 The weighted average of the commissions on the transactions is approximately 1% ofthe principal amount of the trades. 137Most of the Schedule A-35 trades fell into the first category of inflated rate commissionpayments—20 cents or more on transactions of 10,000 shares or more (“Type 1 Trades”), Ozag’soriginal criterion. Enforcement presented additional evidence, however, regarding two of theremaining categories Campbell formulated: non-economic cross or wash trades (“Type 2Trades”) and IPO flips (“Type 4 Trades”). Because these categories present distinct issues, thePanel discusses them in further detail below.133 CX 8.134 JX 14 14 (Joint Stipulations).135 JX 14 14 (Joint Stipulations). Exhibit CX 9 breaks out all of the agency trades by customer. Tr. 197:8-10(Ozag).136 Tr. 247:6-11 (Ozag).137 JX 14 22 (Joint Stipulations).30

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.1. Non-Economic Cross or Wash TradesJust six sets of trades placed by customers GAM and BRM fell into the category of Type2 Trades—20 cents or more on “non-economic cross trades” of 5,000 shares or more. 138Although Enforcement denoted the Type 2 Trades as cross or wash trades, they were neither. 139Indeed, Campbell did not consider Type 2 Trades to constitute “wash sales” or “cross trades.”Campbell testified that he formulated the criterion for Type 2 Trades to catch pairs of trades thathe considered the functional equivalent of Type 1 Trades. That is, he viewed the sale andpurchase of 5,000 shares of the same stock on the same day at commissions of 20 cents per shareor more as the equivalent of a single trade of 10,000 shares at a commission of 20 cents ormore. 140The Panel concluded that the Type 2 Trades were neither wash sales nor cross trades. Bydefinition, a “wash sale” involves no change of beneficial ownership, 141 whereas each sale heredid involve a bona fide change in ownership. And a cross trade entails a simultaneous match by asingle broker-dealer of a buy and sell order from two different customers. 142 Here, each sell orderwas executed in the marketplace through a different broker, and none of the “matched” tradeswas simultaneous.Calling the trades “wash” or “cross” trades inaccurately implied that the trades wereinherently improper. Indeed, Enforcement argued that, from the customers’ perspective, thetrades were economically irrational; thus, the Panel must conclude that GAM and BRM placed138 Id. 25, 31.139 Enforcement did not explain why it referred to the Type 2 Trades as cross or wash trades.140 Tr. 1799:7-17 (Campbell).141 See NASD Marketplace Rule 6440(b)(1).142 Tr. 252:18–253:2 (Ozag).31

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.the trades for an improper purpose—to generate commissions for the Firm’s benefit. 143 However,Green and Raha, Enforcement’s experts who addressed this subject, each testified on crossexaminationthat the Firm did nothing wrong in accepting the commissions on these trades. 144The Panel agrees.Enforcement did not present sufficient evidence to prove that the “inflated ratecommissions” on the Type 2 Trades were improper profit-sharing payments. Enforcement and itsexperts did not interview GAM and BRM or review their prime brokerage accounts.Consequently, Green and Raha could only speculate about the motives behind their trades. 145In addition, Enforcement’s assumption that the trades could only be explained as profitsharing is incorrect. As Enforcement concedes at other points, a customer may do extra businesswith, or pay higher commissions and fees to, a broker in order to be deemed a valued customer.From an economic perspective, this is a legitimate business strategy. And, where a customerinvests its own funds, as did GAM and BRM, such activity is not inherently improper. Unlike abroker or mutual fund, GAM and BRM were under no duty to trade at or near the lowest cost. Inshort, they were entitled to make their own business decisions about the value of the services theFirm provided. The fact that they placed a higher value on those services than Green and Rahawould have is not evidence of profit sharing.143 See, e.g., Enforcement’s Post-Hr’g Br. at 21.144 Tr. 1207:16-19 (Green); Tr. 2203:13-24 (Raha).145 For example, Raha states in his report that GAM appeared to be “engaged in day trading and did not like to takea lot of risk.” CX 36 at 11 (Raha report). Raha defined “risk” as a function of the volatility of the underlying asset,the holding period, and the security’s liquidity. Then, Raha concluded that GAM’s trades were of no “economicbenefit” because they deviated from the typical day-trading strategy. Raha drew this conclusion with no knowledgeof GAM’s operations as a whole. See CX 36 at 11-12 (Raha report).32

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.2. IPO FlipsEnforcement presented evidence regarding a single Type 4 Trade—a trade involvingreceipt of a commission of $1 or more per share on a flip of not fewer than 200 IPO shares. 146Customer JD flipped 200 shares of VA Linux stock on December 9, 1999. 147 Enforcement notedthat the VA Linux IPO was the hottest offering of the 1999–2000 IPO boom. JD purchased theVA Linux IPO at $30 per share and sold the same day at $270 per share, for a gross profit of$48,000. JD paid the Firm a commission of $1,600, or $8 per share. 148Enforcement claimed that the commission was a payment of a share of the profits in JD’saccount because the commission fell within the definition of a Type 4 Trade. The Panelconcluded however that the evidence did not support Enforcement’s conclusion.JD denied that he paid the commission to share profits with his friend and broker, CJ. 149JD testified that he considered CJ a unique resource with 50 years of experience in the securitiesindustry. 150 Over the years, JD relied on CJ’s advice, but JD set the commissions he paid CJindependently. 151As did some of the other customers who testified, JD generally set the amount of grosscommissions he paid brokers annually based on the relative value of the services they provided.146 Other Type 4 Trades appeared in Enforcement’s exhibits, but Enforcement did not present an analysis of any ofthose transactions.147 CX 10 at 4.148 Although the total commission was insignificant, the Panel concluded that Enforcement stressed this tradebecause of VA Linux’s extraordinary first trade premium and the magnitude of the commission rate JD placed onthe trade.149 Tr. 3057:13-17 (JD); accord RX 135 at 06933. In addition, JD testified that he did not consider the $8 per sharepayment to constitute underwriting compensation. Tr. 3062:18–3063:2; 3064:17–3066:4 (JD).150 Tr. 3047:3-9 (JD).151 Tr. 3057:19-21 (JD).33

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.On individual trades generally, JD was guided by NASD’s 5% Policy. 152 When questioned aboutthe VA Linux commission, JD explained that he considered three factors in setting thatcommission. First, he considered the flip of VA Linux an extraordinary event. He stressed thathe had never before made $48,000 in two hours. JD had given the trading desk the authority tosell at the open, using the trader’s best judgment. 153 Given the wild nature of the security, JDconcluded that he had received a “wonderful execution.” 154 Second, JD calculated that thecommission “was well under [NASD’s] 5-percent guideline.” 155 Third, JD considered that he hadpaid CJ less than the total amount budgeted for the year. 156 Thus, he used this extraordinary eventas an opportunity to increase the total.The Panel accepts JD’s testimony that he never considered sharing profits with the Firm.Although Enforcement attempted to discredit JD because he is a friend of CJ and KL, the Panelfound his testimony credible and reliable. In addition, the Panel notes JD’s long anddistinguished background in self-regulation of the securities industry. JD served as a member ofthe Corporate Bond Committee of the Securities Industry Association, as a hearing panelmember for the New York Stock Exchange (“NYSE”), as Chairman of NASD’s District 10Business Conduct Committee, as a member of NASD’s Board of Governors, as a member of152 Under the NASD’s Mark-Up Policy, IM-2440, mark-ups or spreads more than 5% above the prevailing marketprice in equity securities may be considered excessive, and thus violative of NASD Conduct Rules 2110 and 2440,unless justified in light of other relevant circumstances set forth in Conduct Rule 2440 and in IM-2440. See, e.g.,First Independence Group, Inc. v. SEC, 37 F.3d 30, 32 (2d Cir. 1994); District Bus. Conduct Comm. v. First Am.Biltmore Sec., Inc., No. C3A920018, 1993 NASD Discip. LEXIS 235, *19-20 (N.B.C.C. May 6, 1993). Althoughthe 5% Policy does not apply to agency trades of listed securities, brokers often refer to the policy when reviewingthe fairness of commissions charged on such transactions.153 Tr. 3053:8-15 (JD).154 Tr. 3055:6-25(JD).155 Tr. 3057:22-24 (JD).156 JD testified that he, like other institutional customers, set dollar volume targets for the commissions he wouldpay each broker per year.34

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.NASD’s National Business Conduct Committee, and ultimately as Chairman of NASD’s Boardof Governors. 157 The Panel finds no reason to question JD’s integrity.Accordingly, the Panel finds that the Firm did not share in the profits of JD’s account byaccepting the commission on the VA Linux transaction. In addition, the Panel finds thatEnforcement failed to prove that the commissions the Firm accepted on any of the other Type 4Trades were profit-sharing payments.F. No Customer Evidence of Profit SharingEach of the Firm’s customers that cooperated with Enforcement or otherwise providedevidence denied sharing profits with the Firm. They consistently denied profit sharing ininvestigative interviews, in written statements they and their counsel made, in hearing testimony,and in sworn on-the-record interviews taken by Enforcement during its investigation.1. April 2002 Telephone InterviewsIn April 2002, Enforcement’s investigator, Ozag, began calling some of the the Firm’scustomers in order to interview them. 158 Ozag testified, and his interview notes confirm, 159 thatthe customers he spoke to denied sharing profits with the Firm. 160 Indeed, they denied engagingin any of the questionable conduct about which they were asked, and they denied that the Firmhad engaged in improper conduct. For example, they denied that the Firm had ever asked them“to pay back a portion of [their] IPO profits.” 161 They also told Ozag that the Firm did not157 Tr. 3043:8–3045:17 (JD).158 Tr. 224:16–225:2, 343:4-6 (Ozag).159 Tr. 343:7-22, 351:10-14 (Ozag); RX 106 at 6199-6228, 6230-6239.160 Tr. 226:20-25 (Ozag).161 Tr. 344:23–345:6 (Ozag).35

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.“impose[] requirements on the customer in order to receive an allocation of hot issues”; 162 theypaid high commissions to be valued customers and obtain IPO allocations. 163 The customersfurther denied that the Firm “would accept higher than normal commissions on secondary tradesas payment in exchange for allocations,” 164 and denied that the Firm “would accept cash aspayment in exchange for allocations of hot issue IPOs.” 165 And the customers told Ozag that theFirm had not engaged in a quid pro quo. 1662. Customer Statements and MemorandaThe Firm submitted customer statements, affidavits, and counsel letters that wereconsistent with Ozag’s interviews. In September 2002, the Firm produced to Enforcement twobinders of materials reflecting its customers’ understandings of their dealings with the Firm; thefirst was a binder of statements signed by 23 customers, 167 and the second was a binder ofmemoranda reflecting interviews the Firm had conducted with 30 of its customers. 168 The162 Tr. 344:9-20 (Ozag).163 Ozag’s notes reflect how the customers explained that they were simply trying to be valued customers of theFirm. E.g., RX 106 at 6199, 6201, 6203, 6231-33 (“Broker for 18 yrs./ When I allocated IPOs, I did it to biggestaccount/ w/ that in mind, I wanted to be one of the accounts that would/ I wanted to be a big account because bigaccounts get IPOs,” “Tries to be a ‘competitive[’]/‘valued’ client,” “Factors influencing comm. rate/ Wants to be a‘valued competitive’ client,” “Wants to develop a relationship where the brokers are making [them] money—mayinclude getting IPO shares”).164 Tr. 345:11-18 (Ozag).165 Tr. 345:21–346:4 (Ozag).166 Tr. 350:9-14 (Ozag).167 RX 12.168 RX 13.36

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.statements were provided at the Firm’s request. 169 Each signed statement denies that any profitsharing, tie-ins, quid pro quos, or any conversations about these subjects had occurred. 170The 30 interview memoranda similarly deny the existence of any profit sharing, tie-ins,quid pro quos, or any conversations about these subjects. 171 Although the Firm solicited thesestatements, Ozag conceded that the customers would reaffirm the substance of their statementsunder oath if they were called to testify at the hearing. 172 Indeed, Ozag testified that three of thefour statements—that customers set commissions, that there were no tie-ins or quid pro quos,and that there were no discussions about tie-ins—were all categorically true. 173 And as for thefourth statement—the denial of profit sharing—Ozag conceded that the customers were beingtruthful: they did not believe they were sharing profits with the Firm, as they understood themeaning of the term. 174169 Tr. 227:8-13 (Ozag); see also JX 14 74 (Joint Stipulations).170 E.g., RX 12 at 2405. The form statements prepared for the customers by the Firm’s counsel “confirmed” thefollowing facts:1. At all times, I (or my representatives) unilaterally set the commissions on orders placed at theFirm.2. At no time was there ever any tie-in arrangement or quid-pro-quo linking commissions and IPOallocations.3. There were no discussions with the Firm suggesting or implying a tie-in arrangement betweencommissions and IPO allocations.4. I (or my representatives) did not engage in any profit-sharing with the Firm.171 E.g., RX 13 at 2456.172 Tr. 421:5-14 (Ozag).173 Tr. 422:3-12 (Ozag).174 Tr. 422:13–423:10 (Ozag).37

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.3. Customer AffidavitsIn addition, the Firm submitted seven customer affidavits that deny the existence of anytie-in arrangements, quid pro quos, kickbacks, or discussions about linkages betweencommissions and IPO allocations. 175 Enforcement introduced no evidence to contradict theseaffidavits.4. Customer Counsel LettersThe record also includes several exhibits containing various letters to Enforcement fromlawyers representing 14 customers. These exhibits show that these customers offered to confirmin interviews or affidavits that they had not engaged in profit sharing. 1765. Hearing TestimonyThree Firm customers—EB, JD, and SD—testified in person. Enforcement claims thattwo of them, EB and JD, shared profits with the Firm. 177 Both denied the charge.EB, who paid the most total commission dollars of all the other customers on ScheduleA-35, 178 consistently paid 60 cents per share on all his trades 179 although he paid other firms farless. He testified that he paid the Firm 60 cents per share because he valued KL’s advice. 180 In hiswords, KL “either saved me money or made me money.” 181 EB did not vary the rate dependingon the availability of IPOs, and he continues to pay 60 cents per share on all of his trades.175 RX 133-139.176 RX 116-123.177 The third customer, SD, did not purchase IPO shares from the Firm.178 See RX 312.179 JX 14 51 (Joint Stipulations).180 Tr. 4213:22–4214:3; 4236:7-15 (EB).181 Tr. 4218:5-8 (EB).38

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.When questioned about his motive in paying such a high rate, EB denied the existence ofany profit sharing, payback, tie-in, or quid pro quo. In addition, he stated that he had noconversations with the Firm about any of those subjects. 182As discussed above, 183 JD likewise denied sharing profits with the Firm. 184 As was thecase with other Firm customers, JD paid higher commissions to ensure access to the services theFirm provided him. Aside from access to IPOs, these included the investment advice he receivedfrom CJ, his broker, whom JD considered to be a uniquely valuable resource. The Panel creditsEB’s testimony and finds that the Firm did not share in the profits of his account.6. On-The-Record Interview TestimonyEnforcement took on-the-record testimony from several customers during theinvestigation; each denied sharing profits with the firm. 185 Of those, LM’s testimony isparticularly significant because Enforcement pointed to him as the customer who most supportedEnforcement’s profit-sharing theory. The Panel finds otherwise. LM’s on-the-record interviewtestimony actually undercuts Enforcement’s theory. 186LM is an unregistered professional investor who speculates in new issues for his ownaccount. 187 He disclaimed being an “investor,” by which he meant that he did not purchase stockto hold for the long term. 188 His business plan was to concentrate on IPOs. Thus, to maximize his182 Tr. 4215:9–4216:17 (EB).183 See Part III.E.2 at p. 30.184 See discussion infra Part III.E.2.185 Tr. 355:16–356:2 (Ozag).186 LM refused to testify at the hearing because he thought that Enforcement had mischaracterized his on-the-recordinterview testimony. See RX 240 at 10536-37 (LM Aff.).187 CX 38 at 22-23.188 Id. at 72.39

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.ability to acquire IPO shares, he opened accounts at all the firms he could identify as havingaccess to IPOs, including all of the major Wall Street firms. 189 In contrast to a hedge fund, he didnot invest or manage money for others. 190 Nor did he engage in other investment strategiesduring the relevant review period. LM placed agency trades of listed securities through hisvarious brokerage accounts only to get new issues. 191 In other words, he ran business throughbrokerage firms, including the Respondent Firm, to qualify for IPO allocations. 192LM testified that in 1999 and 2000 he used a formula to determine the amount ofcommissions he paid. LM generally tried to limit his commission payments to between 30 and40% of his profits, which he considered a fair and reasonable level. 193 In effect, LM viewed thesepayments as the cost of doing IPO business. LM arrived at this formula without any input fromthe Firm. Indeed, he did not discuss the formula with HB, his Firm broker, or any other broker atany firm. It was just an internal guideline. 194LM’s testimony does not support Enforcement’s claim of profit sharing. LM set hiscommissions without his broker’s involvement. He testified that HB could not have known howmuch profit LM was making on IPOs because LM sold the shares at other firms. LM furthertestified that he did not tell HB what he was making because it was none of HB’s business. 195Indeed, LM testified at his on-the-record interview that he did not share that type of information189 Id. at 17.190 Some of the Firm’s customers labeled as “hedge funds” likewise did not invest customer funds.191 CX 38 at 22-23, 29, 71-72.192 Id. at 13, 27. According to LM, no firm on Wall Street was willing to give hot new issues to customers who didno other business with the firm.193 CX 38 at 63-64.194 Id.195 Id. at 48-49.40

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.with anyone. In effect, Enforcement ignores LM’s repeated and consistent denials of havingreached any agreement with HB regarding the payment of profits. LM testified that there was noarrangement or agreement between himself and HB. 196 Enforcement ignores LM’s testimony thatHB never dictated or suggested the specific commission LM should place on a trade. 197In conclusion, LM’s testimony does not show a profit-sharing arrangement between himand HB. Rather, the Panel concludes that the evidence shows that LM was describing the generalbusiness model he used during the exuberant IPO market of 1999 and early 2000 when hetestified that he tried to limit his commission expenses to between 30 and 40% of his profits.Fundamentally, his goal was to flip hot IPOs, and he was willing to pay upwards of 40% of theprofits he earned on those flips to stay in the game. He could not obtain IPO shares unless he didsufficient non-IPO business to be considered a valued customer. There was no other methodavailable to generate revenue at the firms that had IPO shares. Thus, LM first estimated the levelof revenue he needed and then met that level by trading listed securities. In addition, hesometimes placed higher commission rates on those trades to reduce the burden associated withdoing higher volume. 198 Importantly, Enforcement offered no evidence that LM intended to shareprofits with HB or that HB expected to receive a share of the profits generated in LM’s account.The Panel finds unpersuasive Enforcement’s argument that HB engaged in profit sharingbecause he had a general idea of the amount LM made on the IPOs he received from the Firmand asked LM to throw more commissions his way. Indeed, most brokers, particularly at firms ofRespondent’s size, would have a general idea of the amount their customers made on IPOs thebrokers allocated, but knowledge of that information alone does not equate to profit sharing.196 Id. at 51.197 Id. at 60.198 Id. at 61.41

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.G. Statistical Evidence of Profit Sharing1. OverviewBecause a central element of Enforcement’s theory is that there were obvious patterns ofprofit sharing, each side retained experts to examine the data. Enforcement retained Dr. MichaelG. Ferri (“Ferri”), 199 and the Firm retained Professor Joseph L. Gastwirth (“Gastwirth”). 200 Bothexperts filed reports of their findings and testified at the hearing.As a preliminary matter, the Panel dismisses the Parties’ respective objections to thesetwo experts. The general framework regarding the admissibility of expert testimony, like thestatistical evidence here, is set forth in the Supreme Court’s decisions in Daubert v. Merrell DowPharm., Inc., 509 U.S. 579 (1993) and Kumho Tire Co. v. Carmichael, 526 U.S. 137 (1999). InDaubert, the Court made clear that expert testimony should not be considered in a case unlessthe expert has genuine expertise and that expertise will assist the trier of fact to understand ordetermine a fact issue in the case. 201 The Court elaborated on Daubert’s framework in Kumho199 Ferri holds the Foundation Chair in Finance at George Mason University. He holds a Ph.D. in economics fromthe University of North Carolina at Chapel Hill. He is the co-author with Frank Fabozzi and Franco Modigliani ofthe widely used textbook Foundations of Financial Markets and Institutions. His other publications and researchrelate to financial instruments, rates of return, financial structures, and asset pricing. Dr. Ferri has over thirty yearsof teaching experience. In addition, Ferri is associated with Nathan Associates, Inc., a consulting firm that providesexpert economic, financial, fraud, and forensic accounting analysis and testimony in legal and regulatoryproceedings. CX 33 (Ferri report). Ferri is not a statistician. Tr. 2013:21-25 (Ferri).200 Gastwirth is Professor of Statistics and Economics at George Washington University, where he has taught since1972, and has also taught at Johns Hopkins, Harvard, and the Massachusetts Institute of Technology. He also servedat the National Cancer Institute and the Office of Management and Budget. His many awards and honors include theAmerican Statistical Association Award for Outstanding Applications Article (2002), the Shiskin Award forEconomic Statistics (1998), and a John Simon Guggenheim Foundation Fellowship (1985). Gastwirth has expertisein application of statistics to the law. He authored a two-volume treatise in the field, Statistical Reasoning in Lawand Public Policy (1988), which has been cited repeatedly in the Federal Judicial Center’s Reference Manual onScientific Evidence. See, e.g., David H. Kaye & David A. Freedman, Reference Guide on Statistics, in ANNOTATEDREFERENCE MANUAL ON SCIENTIFIC EVIDENCE 83, 85 n.1, 86, 106 n.77 (West 2004); Shari Seidman Diamond,Reference Guide on Survey Research, in ANNOTATED REFERENCE MANUAL ON SCIENTIFIC EVIDENCE 229, 237 n.33,245 nn.62-63 (West 2004). He also has written many peer-reviewed papers. RX 4 at 245-47, 293 (Gastwirth report);Tr. 3901:16–3904:6 (Gastwirth).201 509 U.S. at 592.42

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.and explained that the twin requirements for expert testimony are relevance and reliability. Theexpert must employ at trial “the same level of intellectual rigor that characterizes the practice ofan expert in the relevant field.” 202 Moreover, the trial court, exercising its gate keeping function,must examine (among other things) the expert’s qualifications, the methodologies used by theexpert, and the relevance of the results to the questions before the jury. The same frameworkprovides appropriate guidance in NASD disciplinary proceedings. 203The Panel further notes that the admissibility of expert opinion evidence is not governedby whether the expert’s opinion is dispositive of the case. No one piece of evidence has to proveevery element of a party’s case; it need only make the existence of “any fact that is ofconsequence” more or less probable. 204 Thus, an expert’s report may fall short of proving a claimyet still remain relevant to the issues in dispute. 205 Applying the foregoing standards, the Panelfinds that both reports are admissible.Once the admissibility of an expert’s report is determined favorably, the Panel next mustdetermine the probativeness of the report. 206 Here, the Panel finds Ferri’s report less probativethan Gastwirth’s. As discussed below in more detail, Ferri’s methodology was less rigorous.Ferri failed to analyze alternative explanations for the patterns he observed and to employ acomparative study to verify the correlations he reported. Accordingly, the Panel rejectsEnforcement’s statistical conclusions of profit sharing.202 Kumho, 526 U.S. at 152.203 However, unlike federal court proceedings, NASD disciplinary proceedings are not subject to formal rules ofevidence. Accordingly, the principles in Daubert and Kumho are not binding.204 See Fed. R. Evid. 401.205 See, e.g., Obrey v. Johnson, 400 F.3d 691, 695 (9 th Cir. 2005) (holding that court erred in excluding expert reportin employment discrimination case).206 Cf., e.g., Bazemore v. Friday, 478 U.S. 385, 400 (1986) (Normally, failure to include variables [in regressionanalysis] will affect the analysis' probativeness, not its admissibility.).43

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.2. Enforcement’s Statistical Evidence—the Ferri-27Enforcement asked Ferri to determine if there were any discernible patterns involving theFirm’s IPO allocations and the commissions that the recipients of the IPO shares paid on non-IPO shares. 207 To analyze this issue, Ferri focused on 27 of the 31 customers who engaged in atleast one “inflated rate transaction” during the review period (the “Ferri-27”). 208 Ferri defined an“inflated rate transaction” as “an agency trade in a non-IPO stock that involved either (1) at least10,000 shares with a commission per share of 20 cents or more or (2) at least 1,000 shares with acommission of at least 75 cents per share.” 209Ferri found three principal correlations that he considered significant: (1) inflated ratetransactions were more frequent on IPO days; 210 (2) total commissions were higher on IPOdays; 211 and (3) total agency commissions paid by the Ferri-27 tended to rise and fall with thesize of their first-trade hypothetical profits. 212(a)Frequency of Inflated Rate CommissionsFerri reached his first conclusion—inflated rate transactions were more frequent on IPOdays—by comparing the frequency of inflated rate transactions on days of hot IPOs with theirfrequency on days when the Firm did not have shares of hot IPOs to sell. In other words, hetested for the degree of association between the timing of the inflated rate commission payments207 CX 33 at 6-7 (Ferri report).208 Enforcement directed Ferri to exclude four customers as well as those customers who only flipped IPO shares.CX 33 at 8 n.6 (Ferri report). Ferri testified that he did not know why Enforcement excluded these customers. Tr.1810:11-24 (Ferri).209 Enforcement gave Ferri this definition based on information its other experts provided. CX 33 at 8 n.5 (Ferrireport).210 CX 33 at 17-18 (Ferri report); Tr. 1927:15-18 (Ferri).211 CX 33 at 12-13 (Ferri report); Tr. 1928:22–1929:14 (Ferri).212 CX 33 at 13–14 (Ferri report).44

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.and the timing of the hot IPOs. 213 From this comparison, Ferri concluded that inflated ratetransactions generally were more likely to occur on IPO days than on non-IPO days. 214 Inaddition, Ferri found that 37% of the Ferri-27 were more likely to engage in an inflated ratetransaction on the day of a hot IPO. 215(b)Higher Total Gross CommissionsFerri reached his second conclusion—that total gross commissions from agency trades innon-IPO shares were higher, in general, on days when the Firm was allocating shares of hot IPOsthan on other days—by comparing the group of total commissions on the days the Firm allocatedhot IPOs with the group of total commissions on other days.Ferri concluded that total gross commissions from agency trades in non-IPO shares werehigher on days when the Firm was allocating shares of hot IPOs than on other days. 216 Ferri alsofound that for the house accounts and three of the sales representatives, total commissions fromagency trades in non-IPO shares were much higher on days when they had shares of hot IPOs tooffer than on other days. And for the fourth sales representative, total commissions from agencytrades in non-IPO shares were larger on days of and following a hot IPO allocation than on otherdays. 217213 Ferri conducted this analysis at three levels. First, he looked at the trading data of the Firm, taken as a whole.Second, he looked at the trading data of the customer-pools of the four sales representatives and the Firm’s houseaccounts. Third, he looked at the trading data of each of the Ferri-27. See CX 33 at 9 (Ferri report).214 CX 33 at 17-18 (Ferri report); Tr. 1927:15-18 (Ferri). As to one registered representative, Ferri found nocorrelation on hot IPO days; however, he did find that there was a similar correlation when he looked at inflated ratetransactions on the day of and following each hot IPO. Tr. 1927:19–1928:9 (Ferri); CX 33 at 13–14 (Ferri report).215 CX 33 at 14 (Ferri report).216 CX 33 at 12-13 (Ferri report); Tr. 1928:22–1929:14 (Ferri).217 CX 33 at 13–14 (Ferri report).45

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.(c)Correlation of Total Agency Commissions and HypotheticalProfitsFerri reached his third conclusion—total commissions from agency trades of non-IPOshares moved in tandem with the total first-trade premium on hot IPOs—by comparing the IPOs’total first trade premium (or hypothetical IPO trading profit) and that day’s total commissionsfrom agency trades in non-IPO shares. 218 Ferri asserted that this comparison enabled him toexamine whether total commissions followed a regular pattern of being relatively large when thetotal first-trade premium was comparatively high, and relatively small when the total first-tradepremium was comparatively low. 219Ferri concluded that, on an aggregate basis, the Firm’s total commissions from agencytrades of non-IPO shares moved in tandem with the total first-trade premium on hot IPOs. 220 Inother words, Ferri reported that he found an association between the commissions andhypothetical profits in the sense that as one went up, the other more often than not tended to goup as well. 221 Ferri also reported very similar results from his study of the house accounts and thefour registered representatives’ accounts. On the other hand, Ferri did not find a consistent ratiobetween commissions and hypothetical profits, which the Firm argued would be necessary toinfer the existence of an agreement to share a set percentage of profits.218 CX 33 at 33 (Ferri report).219 CX 33 at 10 (Ferri report).220 CX 33 at 13–14 (Ferri report).221 Tr. 2239:21–2240:6 (Ferri).46

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.3. The Firm’s Statistical EvidenceGastwirth conducted a far more exhaustive study of the relevant trading data. Gastwirthassembled a team of seven other experts to assist him. Collectively, they spent more than 3,000hours analyzing the data and preparing Gastwirth’s report. 222Gastwirth approached the profit-sharing issue by examining three key questions notaddressed by Ferri: (1) whether the alleged profit sharers were favored by the Firm when IPOallocations were made; (2) whether individual alleged profit sharers paid commissions thatrevolved around a percentage (or a “share”) of their profits; and (3) whether commissionssubstantially higher than six cents per share were unusual at the Firm. 223 From his analysis ofthese issues, Gastwirth concluded that there was no reliable statistical evidence of profit sharing.(a)Profit Sharers were not FavoredGastwirth formulated his starting question of whether the Firm favored the alleged profitsharers in response to Enforcement’s allegation that the Firm was accepting “bribe-like”payments from its customers. Gastwirth reasoned that “one would expect that the givers of‘bribe-like’ ‘kick-backs’ would get preference in IPO allocations.” 224 The Firm argued that insuch a scenario, an incentive would exist for the broker to give the customer more shares, which222 Enforcement argued that the Panel should exclude Gastwirth’s report because it was too complicated to behelpful to the Panel. See Enforcement’s Post-Hr’g Br. at 1, 41. The Panel rejects Enforcement’s argument. UnderRule 702 of the Federal Rules of Evidence, expert testimony is admissible if it “will assist the trier of fact tounderstand the evidence or to determine a fact in issue.” The admissibility of evidence in NASD disciplinaryproceedings is governed by Rule 9263, which provides that “[t]he Hearing Officer shall receive relevant evidence,and may exclude all evidence that is irrelevant, immaterial, unduly repetitious, or unduly prejudicial.” There is nospecific NASD rule concerning expert testimony; accordingly, NASD looks to Federal Rule of Evidence 702 forguidance. See, e.g., OHO Order 99-11, No. C8A990015 (June 17, 1999); OHO Order 99-03, No. C02980073 (Mar.23, 1999). Expert testimony is particularly helpful here because the Panelists do not have expertise in statisticalanalysis.223 RX 4 at 255-56, 269-79, 287-90 (Gastwirth report).224 RX 4 at 255-56 (Gastwirth report).47

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.would result in greater IPO profits, and, in turn, greater profit-sharing payments. Gastwirthperformed four studies, each of which reflected no statistically significant evidence of favoritismor profit sharing. 225(1) Access to IPOsIn Paragraph 21 of the Complaint, Enforcement alleges “[Respondent] allocated shares inat least one hot IPO to every customer who paid inflated commissions of 20 cents or more on atrade of 10,000 shares or more on at least one occasion in the review period.” In other words,100% of such customers received at least one hot IPO. Because the evidence likewise showedthat customers who did not pay inflated rate commissions also received hot IPO allocations,Gastwirth sought to determine whether the factual allegations in Paragraph 21 of the Complaintwere statistically significant. 226As a starting point, Gastwirth noted that to draw a statistical inference concerning causalrelationships, he had to compare the group of alleged profit sharers to a comparison group ofsimilar customers, which Ferri did not do. 227 Gastwirth constructed two comparison groups: (1)the “non-Ferri-27,” a group of similar customers who are not alleged to have shared profits; and(2) the “MR-30,” a group of 30 customers who, like the Ferri-27, made multiple IPO requests. 228225 Tr. 3937:4-14 (Gastwirth).226 In statistics, “significant” is a technical term, meaning “not attributable to chance-like variation.”227 RX 4 at 250-51 and n.3 (Gastwirth) (citing D.H. Kaye & D.A. Freedman, Reference Guide on Statistics,REFERENCE MANUAL ON SCIENTIFIC EVIDENCE 93-96 (Federal Judicial Center 2000); Tr. 3937:19-3940:25(Gastwirth); see also RX 4 at 313 (Ex. 3).228 The MR-30 group is comprised of customers never accused of profit sharing who, like the alleged profit sharers,requested IPOs eight or more times. There are 30 such multiple requestors—hence, the name “MR-30.” Ferritestified he did not identify any better control group or indeed “reach[] any conclusion about possible controlgroups.” Tr. 2365:7-11, 2364:10-11 (Ferri).48

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Gastwirth found that there was no statistical difference between the Ferri-27 and the twocomparison groups. The non-Ferri-27 experienced a success rate of 94.5% percent, 229 and theMR-30 did exactly as well as the Ferri-27—they also experienced a 100% success rate. 230 Thus,Gastwirth concluded that the Ferri-27 were not favored with IPO allocations.(2) Success RatesGastwirth also looked at customer average “success rates,” or the proportion of IPOallocations a customer requested that were granted. For example, if a customer requested 10allocations and received 7, the success rate is 70%. Gastwirth hypothesized that this inquiry isappropriate because, logically, profit-sharing customers should do better than those who did notshare profits. 231 Put another way, he questioned why sophisticated investors would pay out asubstantial share of their profits and receive nothing in return.Gastwirth found that the average success rates for all customers were similar. The rate forthe Ferri-27 was 89%, the rate for the non-Ferri-27 was 88%, and the rate for the MR-30 controlgroup was 85.7%. 232 Again, Gastwirth concluded that the differences were not statisticallysignificant.In addition, Gastwirth tested the distribution of success rates because the average successrate did not provide a full summary of the data, and a few very large or small observations couldskew the average rate. 233 Gastwirth found that the Ferri-27 actually experienced lower success229 See RX 4 at 257 (Illustration No. 2), 313 (Ex. 3) (Gastwirth report).230 Tr. 3940:10-14 (Gastwirth). In addition, Gastwirth ran parallel studies for other groups of customersEnforcement had identified as profit sharers. These studies likewise showed no favoritism. See RX 4 at 311 (Ex. 2),462-73 (Exs. 24-29) (Gastwirth report).231 See Tr. 3941:23–3942:9 (Gastwirth).232 RX 4 at 257-260 (Gastwirth report); see also RX 4 at 258 (Illustration 3), 315-322 (Exs. 4, 5) (Gastwirth report).See also Tr. 3942:16-23 (Gastwirth).233 RX 4 at 259 (Gastwirth report).49

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.rates than the non-Ferri-27 and that there was no statistically significant difference between thesuccess rates for the Ferri-27 and the MR-30 control group. 234 Thus, Gastwirth concluded that therelative success rates provide no evidence that the Firm favored the Ferri-27. 235(3) Expectancy AnalysisGastwirth also performed what he termed an expectancy analysis. Whereas the successrateanalysis examined the number of offerings in which a customer received an allocation inrelation to the number of offerings the customer requested, the expectancy analysis looked at thenumber of shares allocated to customers. Gastwirth compared the number of shares thecustomers actually received with the number of shares that they would have been expected toreceive relative to a particular benchmark for an allocation criterion. 236The benchmark utilized to compute the expected number of shares was the customers’previous 12 months’ aggregate commission business. 237 Thus, if 10 customers asked toparticipate in an offering, Gastwirth tallied the historical commissions for each of those 10customers over the 12 months ending November 1999; then, to compute the expected number ofshares for each customer, he multiplied the Firm’s retention (e.g., 10,000 shares) by thepercentage of historical business represented by each of the 10 customers. (If the 10 customersasking for an offering paid a total of $1 million in aggregate commission business and Customer234 See RX 4 at 260 (Illustration 4), 315-22 (Exs. 4, 5) (Gastwirth report); Tr. 3943:17–3945:7 (Gastwirth). Todouble check his conclusion, Gastwirth conducted a regression analysis of the success rates of the two groups todetermine whether controlling for other possible factors might show that the Ferri-27 customers received morefavorable treatment than the MR-30 group. The result of this analysis showed that being a member of the Ferri-27group did not have a statistically significant relationship with the number of successful requests for IPO shares. RX4 at 490 (Ex. 33) (Gastwirth report).235 Tr. 3945:11-17 (Gastwirth).236 Tr. 3946:13-18; 4060:3-24 (Gastwirth); RX 4 at 261 (Gastwirth report).237 Tr. 3951:20–3952:17 (Gastwirth).50

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.A paid $100,000 or 10% of the total, Customer A could be expected to get 10% of the retention,or 1,000 shares.) Gastwirth performed the same computations for all of the IPOs, and thus wasable to compute the total number of shares expected by customers based on historical businessfrom all 57 IPOs.Gastwirth found that the alleged profit sharers did not get more than their expected, orproportionate, share—they received less. The Ferri-27 received approximately 1.3 millionshares, while they would have expected approximately 1.8 million shares; their shortfall was 0.5million shares. 238 In percentage terms, they received 41.04% of shares allocated versus theirexpected rate of 57.9%. The shortfall was 16.9% in absolute terms, and 29.2% in relative terms(16.9% divided by 57.9%). The alleged profit sharers thus received, on average, only 71 sharesfor every 100 shares they could be expected to receive based on their proportion of historicalcommission business. 239Gastwirth also analyzed whether the alleged profit sharers who were house accounts werefavored over other house accounts, and separately analyzed whether non-house accounts(serviced by the brokers) alleged to have been profit sharers were favored over the other nonhouseaccounts. In each case, Gastwirth found that the Ferri-27 received fewer shares than theirexpected allocations. 240238 RX 4 at 262 (Illustration 5) (Gastwirth report).239 Tr. 3952:18-3953:17 (Gastwirth). In addition, Gastwirth looked at the expectancy rates for all 110 offeringsduring the review period. The results were similar. In percentage terms, the Ferri-27 experienced a shortfall of16.78% in absolute terms, and 25.72% in relative terms, on all 110 offerings. Similarly, the percentage shortfallswere 16.63% in absolute terms, and 22.26% in relative terms, for the secondary offerings. RX 4 at 262 (Illustration5) (Gastwirth report).240 Tr. 3955:20–3957:6 (Gastwirth).51

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.To test for any bias in the results that might result from the fact that the brokers receivedonly 35% of the available IPO shares and the house accounts received the remainder, Gastwirthperformed an “adjusted expectancy analysis.” For this analysis, Gastwirth assumed that Ferri’scriteria for “inflated rate transactions” 241 were in place at the time of the trading. Thus, Gastwirthadjusted the commission rates paid by the alleged profit sharers to those levels. Everycommission of 20 cents per share or more on a trade of 10,000 shares or more was reduced to 19cents per share, and every commission of 75 cents per share or more on a trade of 1,000 shares ormore was reduced to 74 cents per share. 242 The adjusted expectancy analysis likewise showedthat the Ferri-27 customers were disadvantaged, albeit by smaller margins. 243In addition, Gastwirth individually examined each IPO highlighted in the Complaint, 244and found a similar absence of evidence of favoritism for alleged profit sharers in each suchoffering. For example, for the VA Linux offering, the calculated expectancy rate for the Ferri-27was 53.2%, yet Gastwirth found that they received 30.8% of the shares, an absolute shortfall of22.4% and a relative shortfall of 42.16%. The same held true for each of the other IPOshighlighted in the Complaint. 245241 Twenty cents per share on trades of 10,000 shares or more, and 75 cents per share on trades of 1,000 to 9,999shares or more.242 See Tr. 3957:7–3962:15 (Gastwirth); RX 4 at 263-64, 329-32 (Ex. 7) (Gastwirth report).243 RX 4 at 331 (Gastwirth report); Tr. 4002:7-11 (Gastwirth). In addition, Gastwirth performed the same “adjustedexpectancy analysis” separately to determine if the Ferri-27 who were house accounts were favored over otherhouse accounts, and similarly to see whether the Ferri-27 non-house accounts were favored. Gastwirth concludedthat they were not. The Ferri-27 house accounts received slightly less shares than would have been expected. TheFerri-27 broker accounts received 13% less shares than would have been expected. Tr. 3962:16–3963:4 (Gastwirth).244 Tr. 3963:5-22 (Gastwirth); RX 4 at 266-67, 341-43 (Gastwirth report).245 Tr. 3963:12-16 (Gastwirth); RX 4 at 267 (Illustration 11) (Gastwirth report).52

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.(4) Favoritism Relative to Retail CustomersFinally, Gastwirth examined whether retail customers were disadvantaged relative to theFerri-27. He first compared the success rates of the two groups, which showed that retailcustomers as a group were successful 97.95% of the time, and the Ferri-27 were successful89.58% of the time. Gastwirth also performed a more detailed comparison that showed on anIPO-by-IPO basis that both groups had virtually equal success rates. 246 Thus, Gastwirthconcluded that here also the Ferri-27 were not favored. Gastwirth’s conclusion directlycontradicted Enforcement’s hypothesis that the Schedule A-35 customers were sharing theirprofits in order to be favored with a greater number of hot IPO shares.(b)No Consistent Ratio of Commissions to Hypothetical ProfitsGastwirth next examined the degree of consistency of the relationship between thecommissions paid by the Ferri-27 and their hypothetical profits on allocated IPO shares.Gastwirth theorized that if he found substantial variation in the ratio of commissions tohypothetical profits, it would be difficult to conclude that the customers, either unilaterally or inagreement with their brokers, were paying a targeted “share” of their profits back to the Firm.Gastwirth considered this a relevant inquiry because the Complaint singled out one customerwho had the alleged practice of paying back 30-40% of his profits. 247 Moreover, the Complaintalleged that the Firm typically received inflated rate commission payments on the day, or within246 Tr. 3963:23–3964:14 (Gastwirth); RX 4 at 268-69, 345-46, 527 (Gastwirth report).247 Compl. 28.53

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.one day, of an IPO. 248 If these allegations were true generally, Gastwirth theorized that the datawould reflect a fairly consistent ratio of commissions to hypothetical profits. 249To analyze this question, Gastwirth performed two studies.(1) Variability StudyIn the first study, Gastwirth examined the level of variability of commissions tohypothetical profits. To do so, he first computed a ratio for each customer on or around an IPOby dividing commissions by hypothetical IPO profits (a “C/HP Ratio”). 250 Gastwirth then usedtwo measures of variability to assess whether these daily fractions were concentrated around a“target fraction” or “target share.” 251The first measure of variability Gastwirth used is the Gini Index of Income Inequality. Innon-technical terms, the Gini index provides a standard benchmark of inequality for comparativepurposes. For example, household income in the U.S., which generally is considered to be quiteunequal, has a Gini index of about .45. Statisticians consider higher values to indicate greaterinequality. Here, Gastwirth found that the Gini index of the C/HP Ratios for the Ferri-27 andother groups of customers indicated a very high degree of inequality. Even when the data wererestricted to days with a positive hypothetical profit, the Gini indices for all groups exceeded .88.Only two customers had a Gini index below .45. 252248 Id. 2.249 The converse would not be as conclusive because a high level of consistency could be the result of thecustomers’ unilateral decision to pay inflated rates as opposed to an agreement to do so. See Tr. 3965:14-3966:15(Gastwirth).250 Gastwirth ultimately tested the data using one, two, and three day windows around the IPO days. The results foreach were consistent.251 Tr. 3967:25–3973:22 (Gastwirth); RX 4 at 269-76 (Gastwirth report).252 Tr. 3971:3-7 (Gastwirth).54

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.The second measure of variability Gastwirth used is the “coefficient of dispersion,”which is a standard measure of the variability of assessment-sales ratios that is used to evaluatewhether real estate tax assessments are uniform. Statisticians generally regard values of thecoefficient of dispersion greater than .40 as indicating that the assessment-sales ratios are notuniform. Thus, values for the C/HP in excess of .40 would indicate that the C/HP Ratios are notconcentrated about a central value (their median) and, thus, are highly variable.Gastwirth found that the values of the coefficient of dispersion of the C/HP Ratio for thealleged profit sharers indicate a substantial degree of variability. Indeed, every group ofcustomers Gastwirth studied had a coefficient of dispersion exceeding 5.0, which Gastwirthconsidered an extreme degree of non-uniformity. In addition, viewed individually, all of theFerri-27 customers had values greater than 1.0. 253(2) Correlation StudyGastwirth also examined whether the C/HP Ratio varied with the magnitude of thehypothetical profit. 254 Gastwirth considered this an appropriate subject of study because, hereasoned, if there was an agreement or arrangement to share profits one would not expect the“share” to increase or decrease with the amount of the hypothetical profit. In other words, if acustomer was paying a target amount (e.g., 30%) of his profits to the Firm, the percentage wouldnot be expected to vary when the hypothetical profits increased or decreased. Rather, the ratiowould remain relatively constant. 255253 Gastwirth further notes that for seven customers a coefficient of dispersion could not be calculated because theypaid no commissions on more than half of the days they received hot IPO shares.254 See Tr. 3973:23–3978:6 (Gastwirth); RX 4 at 276-79 (Gastwirth report).255 Tr. 3975:18-3976:6 (Gastwirth).55

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Gastwirth discovered that there was a negative correlation between the C/HP Ratio andthe hypothetical profit. When profit rose, the customers as a group paid less as a fraction ofprofit. 256 Gastwirth concluded that this negative correlation tended to indicate the absence of anagreement or arrangement for the sharing of profits.(c)Rates above Six Cents per Share were not UncommonGastwirth next examined Enforcement’s conclusions about the relative rarity ofcommissions in excess of six cents per share. 257 Gastwirth noted that Campbell, Enforcement’sprimary expert on commission rates, had reported that industry-wide commission rates forinstitutional customers during the relevant period typically ranged between four and ten cents pershare, depending upon the nature of the transaction and services rendered. 258 Accordingly,Gastwirth thought it appropriate to examine how common rates above those levels were at theFirm during the relevant period, particularly for customers of a similar size to those thatcomprise the Ferri-27.Gastwirth first studied commissions paid over two periods, the relevant period under theComplaint and the 12 months preceding the Complaint. For both periods, Gastwirth concludedthat it was not unusual in a statistical sense to have commissions at the Firm outside the range offour cents to ten cents. Slightly more than 40% of the commissions in these periods were eitherbelow four cents or above ten cents per share. 259256 See Tr. 3976:8-25 (Gastwirth); RX 4 at 278 (Gastwirth report); see also RX 4 at 359-63 (Gastwirth report). Theprobability of this occurring randomly “was less than 1 in 10,000.” Tr. 3977:9 (Gastwirth); see also RX 4 at 277(Illustration 17) (Gastwirth report).257 Gastwirth performed this study in the context of a broader review of the integrity of Enforcement’s evidenceregarding the Ferri-27 customers’ “pattern” of paying increased commissions on IPO days. RX 4 at 279-90(Gastwirth report).258 CX 32 at 6 (Campbell report).259 RX 4 at 288 (Gastwirth report).56

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Gastwirth also examined the frequency of commissions at or above 10 and 20 cents pershare. Again, he found that commissions at those rates were not uncommon during both periods.For example, commissions of 10 cents or more per share happened 39.55% of the time during thereview period, and commissions of 20 cents or more per share happened 28.53% of the timeduring the same period.In addition, in terms of cents per share, Gastwirth found that the commissions had arelatively high degree of “variability,” which he demonstrated using both Gini indices (.574) andcoefficients of dispersion (1.274). 260 He reported similar values for the pre-Complaint period. 261At the hearing, Gastwirth supplemented his findings to address Enforcement’s criticismthat Gastwirth had not excluded trades outside of Enforcement’s inflated rate commissionmatrix. Gastwirth therefore limited his supplemental review to trades of 1,000 shares or moreand added a third commission threshold of seven cents per share. Gastwirth found that trades inall reported categories were significantly more common than Enforcement had argued. At aminimum, nearly 1 out of 5 trades involved a commission rate equal to or greater than 20 centsper share. 262 In addition, Gastwirth noted that the average commission during the 12 monthsimmediately before the review period was 21.6 cents per share and that there were thousands oftrades above 20 cents per share. 263Gastwirth’s findings regarding the relative common occurrence of commission rates inexcess of six cents per share are significant because they undercut Enforcement’s argument that260 See RX 4 at 389 (Ex. 21) (Gastwirth report).261 See RX 4 at 288 (Gastwirth report).262 RX 313 and RX 314.263 RX 4 at 288, 384-86 (Gastwirth report).57

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.the pattern of inflated rate commission payments on or around IPO days was so dramatic as toconstitute notice that the Firm’s customers were making profit-sharing payments to their brokers.4. Enforcement’s Statistical Evidence Lacks Probative ValueEnforcement argued that the Panel can infer from Ferri’s correlations that the Firm (1)participated in profit sharing and (2) knew or should have known that its customers were payingback a share of their profits to the Firm. The Panel disagrees.As a starting point, the Panel notes that correlation is not causation. 264 “Statisticalassociations or correlations only represent the first step in determining whether there is a causalrelationship.” 265 To verify if an observed correlation is causally related, a similar comparisongroup must be employed. 266 Absent such a comparison, the correlation is not reliable. Here, Ferridid not make such comparisons to verify his conclusions. Therefore, the Panel finds that hisfindings lack probative value. Hence, the Panel cannot infer from Ferri’s correlations that theFirm participated in profit sharing.The significance of Ferri’s conclusion that “inflated rate transactions were more likely tooccur on days of hot IPOs” 267 is lessened by the fact that the Ferri-27 were selected because theyhad paid rates Enforcement defined to be “inflated.” Most of these customers—as the othercustomers interested in IPOs (the MR-30 268 )—clustered their trading on IPO days. Thus, asGastwirth observed, it would be logical to find that the Ferri-27 paid inflated rate commissions264 E.g., Wessmann v. Gittens, 160 F.3d 790, 804 (1 st Cir. 1998) (citing Tagatz v. Marquette Univ., 861 F.2d 1040,1044 (7th Cir. 1988)); Ste. Marie v. Eastern R.R. Ass'n, 650 F.2d 395, 400 (2d Cir. 1981) (Friendly, J.).265 RX 4 at 283 (Gastwirth report).266 See REFERENCE MANUAL ON SCIENTIFIC EVIDENCE 336 (Federal Judicial Center 2000).267 CX 33 at 17-18 (Ferri report).268 RX 4 at 578-79 (Ex. 58) (Gastwirth report); Tr. 3983:24–3984:3 (Gastwirth).58

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.on IPO days because they placed most of their trades on those days. 269 For the same reasons, theirtotal commissions would be higher on those same days. The observed correlations, therefore,shed little or no light on the issue of profit sharing.With respect to Ferri’s observation that the Ferri-27 paid higher commissions on IPOdays, Gastwirth studied a control group, the MR-30, that was comprised of customers who hadnever been accused of profit sharing to determine if Ferri’s finding was significant. Gastwirthfound that the control group also showed a statistically significant increase of commissions onIPO days. Approximately 71% of the comparisons showed total commissions higher on IPOdays than on non-IPO days; 270 the comparable statistic for the Ferri-27 was 74%. Gastwirthconcluded that the difference was not statistically significant. Indeed, for all groups Gastwirthstudied, this was the general phenomenon. 271 Moreover, Gastwirth demonstrated that when thecustomers for whom there are statistically significant results are viewed individually, more hadhigher aggregate commissions on non-IPO days. 272Another factor undercutting the probative value of Ferri’s analysis is that he pooled twotypes of “inflated rate” transactions—20 cents or more on trades of 10,000 shares or more, and75 cents or more on trades of between 1,000 and 9,999 shares—which categories he admittedwere “statistically significantly different.” 273 Ferri could not say whether the pooling of the twogroups skewed his findings. 274 In contrast, Gastwirth independently studied the 20-cent group269 Tr. 3983:3-7 (Gastwirth).270 RX 4 at 282-83 (Gastwirth report).271 Tr. 3992:18 (Gastwirth).272 Tr. 3989:23–3990:21 (Gastwirth). Ferri conceded the same thing. Tr. 2350:17-22 (Ferri).273 Ferri did not study the remaining two categories of inflated rate transactions specified in the Bill of Particulars.274 Tr. 2323:11-12 (Ferri).59

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.and the 75-cent group and found that rates of 75 cents or more per share on trades of 1,000 to9,999 shares actually were less frequent on IPO days for the Ferri-27. 275 In addition, Ferriincorrectly concluded that 75-cent trades “almost never happen[ed] on non-IPO days.” 276Gastwirth’s report demonstrated this error.The Panel also finds that Ferri’s analysis of total commissions paid by the Ferri-27 is lesshelpful than Gastwirth’s analysis of the commission rates they paid. As the Firm argues,Enforcement’s Complaint is grounded on the theory that the Firm engaged in profit sharing byaccepting inflated rates, measured in cents per share. Enforcement has never asserted thatincreased order flow on IPO days constituted profit sharing. Nevertheless, Enforcement did notask Ferri to analyze commission rates. On the other hand, Gastwirth did look at commissions interms of their percentage to the value of the trades placed by the Ferri-27 and found that thepercentages were lower on IPO days. 277 “[I]n percentage terms, for the Ferri-27, the percentagewas statistically significantly lower on the IPO days.” 278 In addition, Gastwirth found thatcommissions in cents per share terms were not higher on IPO days. 279 To the contrary, for theFerri-27, the average commission was higher on non-IPO days—23.4 cents (non-IPO days)versus 19.5 cents (IPO days). 280 Although Gastwirth concluded that this was not a statisticallysignificant difference, it nevertheless calls into question the reasonableness of the inferencesEnforcement draws from Ferri’s study.275 Tr. 3984:5-3985:4 (Gastwirth); see RXs 704, 705.276 Tr. 1976:5-10 (Ferri).277 RX 4 at 286 (Gastwirth report).278 Tr. 3988:19-22 (Gastwirth).279 RX 4 at 285, 374-77 (Exhibit 18) (Gastwirth report).280 Tr. 3988:4-5 (Gastwirth).60

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Similarly, the Panel concludes that it cannot infer profit sharing from the fact that Ferrifound a correlation between the total commissions paid by the Ferri-27 and the size of the totalfirst-trade premium of the hot IPOs. 281 As Gastwirth concluded, this was equally true for the nonprofitsharers. In other words, here again the phenomenon was general in nature and not limitedto the Ferri-27. 282 The correlation also was positive for both the MR-30 and the non-Ferri-27control groups. 283 Gastwirth demonstrated that there was virtually no correlation between totalcommissions and cents per share for the Ferri-27.Enforcement did not produce a statistical analysis challenging any of Gastwirth’sfindings. On the other hand, the Firm did present corroborating expert opinion. Dr. VincentWarther (“Warther”), 284 a financial economist, testified that the economic evidence does notsupport Enforcement’s charge that the Firm shared in its customers’ profits. Warther based hisopinion on, among other things, two findings he developed from his analyses of the trading datain this case, which are consistent with Gastwirth’s statistical work. First, Warther found that“there are many examples that contradict [Enforcement’s] claims of [a] relationship between IPOallocations and inflated commissions.” 285 Second, he found that “there is no consistent ratio ofcommissions to IPO profits.” 286281 CX 33 at 10 (Ferri report).282 Tr. 2357:24–2358:6 (Ferri).283 Tr. 3995:7-11 (Gastwirth).284 Warther is a Senior Vice President with Lexicon, Inc., a consulting firm that specializes in the application ofeconomics to issues that arise in legal and regulatory proceedings. Warther holds a Ph.D. in finance and a M.B.A.from the University of Chicago. He has served on the faculties of the University of Michigan Business School, theUniversity of Chicago Graduate School of Business, and the University of Southern California School of Businesswhere he taught finance courses at both the undergraduate and graduate levels. RX 11 (Warther report).285 Tr. 3237:2-5 (Warther).286 Tr. 3237:6-7 (Warther).61

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.First, Warther examined trading data before, during, and after the relevant period todetermine how well it fit the patterns Enforcement claims are revealed by Ferri’s study. Wartherfound a significant number of exceptions.Warther started by examining the 695 allegedly violative trades on Schedule A-35. Foreach transaction, he looked to see if the customer who made the trade received an IPO allocationwithin the three-day window used by Enforcement. Warther found many transactions were notassociated with IPO allocations. 287Specifically, Warther found 113 instances where the alleged profit sharers paid “inflated”commissions within the three-day window around an IPO without receiving an allocation fromthe Firm. 288 He also found 473 instances where the Firm allocated IPO shares to a member of theFerri-27 group, but the customer did not make a Schedule A-35 trade in the three-day windowaround the IPO. 289 And when he broadened the definition of “inflated” commissions to includecommissions greater than 7 cents per share on trades of 1,000 or more shares, he found 223instances where alleged profit sharers received an allocation without paying an “inflated”commission in the corresponding three-day window. 290In addition, Warther ran these same analyses for all the Firm’s customers over the reviewperiod, as well as for the six-month period before the review period, and reached the sameconclusion. He found many transactions that did not fit Enforcement’s inferences. 291287 Tr. 3237:2-17 (Warther).288 Tr. 3238:6-21 (Warther); RX 11 at 2034, 2051 (Ex. B) (Warther report).289 Tr. 3241:17–3242:13 (Warther); RX 11 at 2034, 2057 (Ex. C) (Warther report).290 Tr. 3242:14-3243:8 (Warther); RX 11 at 2034-35, 2078 (Ex. D) (Warther report).291 Tr. 3243:16-21 (Warther); RX 11 at 2035-36, 2088, 2175, 2226, 2266, 2283, 2315 (Exs. E, F, G, I, J, K)(Warther report).62

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Second, Warther studied Ferri’s correlation between commissions and hypotheticalprofits and found, as did Gastwirth, that there was no consistent pattern of so-called kickback orprofit-sharing ratios. 292Finally, Warther seconded Gastwirth’s criticisms of Ferri’s methodology. Like Gastwirth,Warther pointed out that Ferri had failed to take into account alternative explanations. 293 Ofsignificance, Warther determined that total volume was higher around IPO days than non-IPOdays; 294 total commissions on non-“inflated” trades were higher around IPO days than non-IPOdays; 295 and total “low” commissions (commissions less than or equal to six cents per share) werehigher on IPO days than non-IPO days. 296 Warther testified that these findings were statisticallysignificant 297 and consistent with the idea that “business was generally greater around IPOallocations.” 298 Accordingly, he concluded that an inference of profit sharing could not be basedon the association of inflated rate transactions on or around IPO days.As for Ferri’s conclusion that inflated rate transactions were positively correlated withhypothetical profits, Warther agreed with Gastwirth’s finding that this was a generalphenomenon. Total dollar volume of trading at the Firm moved in tandem with IPO profits. Totalcommissions on non-inflated commissions moved in tandem with IPO profits. And total292 Tr. 3244:5-23 (Warther).293 Tr. 3255:2-3 (Warther).294 Tr. 3257:5-7 (Warther); RX 11 at 2042, 2391 (Ex. V) (Warther report).295 Tr. 3257:17-19 (Warther); RX 11 at 2042, 2393 (Ex. W) (Warther report).296 Tr. 3257:20-3258:7, 3260:2–3261:3 (Warther); RX 11 at 2042, 2395 (Ex. X) (Warther report).297 Warther used a level of significance of 5% because he considered it consistent with proper science method. Tr.3258:10-15 (Warther).298 Tr. 3256:14-18 (Warther).63

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.commissions on low commission trades moved in tandem with IPO profits. 299 Warther testifiedthat these findings, too, were statistically significant. 300And like Gastwirth, Warther noted that one of Ferri’s analyses purporting to show thatthe Ferri-27 paid higher total commissions on IPO days (Table XVI of Ferri’s report) actuallycontained more statistically significant results against that hypothesis than it did in favor of it. 3015. Conclusion Regarding Statistical EvidenceAt the hearing, Enforcement argued that its “pattern evidence” proved both the fact ofprofit sharing and the fact that the Firm must have known that its customers were paying theFirm a share of the profits in their accounts. The Panel rejects both arguments.While Ferri identified several correlations between the commissions the Firm receivedand the timing of hot IPOs during the review period, his report did not prove profit sharing. And,due to the methodology Ferri used, the Panel cannot draw a reasonable inference of profitsharing from his findings. Enforcement has not produced sufficient evidence to meet theshortcomings in Ferri’s analysis, as demonstrated by the Firm’s experts. Accordingly, the Panelrejects Enforcement’s statistical evidence of profit sharing. And, since the Panel has found noother evidence of profit sharing, Ferri’s correlations do not constitute red flags of potentialwrongdoing.299 Tr. 3259:5-12 (Warther); RX 11 at 2391, 2393, 2395 (Exs. V, W, X) (Warther report).300 Tr. 3259:17-22 (Warther).301 Tr. 3263:16–3266:22 (Warther); see RX 11 at 2399 (Ex. Z) (Warther report); CX 33 at 31 (Table XVI) (Ferrireport).64

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.H. The Firm’s IPO Allocation PracticesThe Firm’s IPO allocation practices were consistent with those of the industry in general.At the beginning of each week, the Firm generated a list of syndicate offerings, which itcirculated to the Firm’s registered representatives. 302 Each registered representative would thentake indications of interest from his customers. Most of the time, customers were aware ofupcoming offerings, in which case they would initiate a call to their broker if they wished toparticipate in the offering. In other cases, the registered representatives would call theircustomers and inquire if they had an interest in an upcoming offering. 303 Then, the registeredrepresentatives would allocate the IPO shares they received among those customers whosubmitted an indication of interest. 304Generally, the registered representatives at the Firm used three criteria to allocate IPOshares. 305 The most important criterion was the aggregate level of business each customer didwith the Firm. Customers’ historical aggregate commissions were reported on the Schedule ofInstitutional Income prepared by JB’s assistant. 306 Typically, the registered representativeslooked at revenue levels for the last 12 months. The Schedule of Institutional Income did notreflect separately the commission levels customers paid on or around IPO days, nor did it reflectthe commissions on a cents-per-share basis. Indeed, the Schedule of Institutional Income did notinclude data that would have permitted the calculation of a cents-per-share commission rate. The302 Tr. 917:7-10 (Link).303 Tr. 917:16-18 (Link).304 The Firm allocated between 65% and 70% of the shares it received to the house accounts. The Firm divided thebalance among its registered representatives to be allocated to their customers. Tr. 1319:2-13 (LS). The Firmtypically received no more than 1% to 1.5% of any offering. Tr. 1323:8-10 (LS).305 JX 14 56 (Joint Stipulations); Tr. 1319:21–1320:20 (LS).306 JX 15; Tr. 1327:9–1328:13 (LS).65

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.second criterion was the customer’s expressed interest in becoming a holder of the stock. 307 Andthe third criterion was the potential for future business. Each registered representative, however,was free to make the allocations among his customers as he saw fit. The Firm provided nodirection on how to allocate the shares among the customers who indicated an interest in anoffering. 308I. The Firm’s Supervisory SystemThe only witness to directly address the Firm’s supervisory system and writtenprocedures in any detail was Lorena J. Kern (“Kern”), one of the Firm’s experts, who the Panelcredits. 309 The Panel found Kern to be forthright, and her report to be based upon a thorough,unbiased review and analysis of the facts and circumstances of this case. The Panel finds nomerit in Enforcement’s argument that her opinion is biased because she was the Director ofCompliance for the retail division of Morgan Stanley, which itself was under investigationregarding its IPO allocation practices to its institutional customers at the time of the events inquestion in this case. 310 Kern was not involved with Morgan Stanley’s institutional business or307 JX 14 56 (Joint Stipulations).308 Tr. 1004:10-24 (Smith).309 Kern is a partner at Ferguson Pollack Kern Consulting LLC (“FPK”), a consulting firm that specializes inproviding support to in-house counsel and compliance professionals within the securities industry. FPK claimsnearly every major brokerage firm as a past or present client. Kern, a graduate of Fordham Law School, hasextensive experience as a securities lawyer. Before joining Morgan Stanley, She served as a staff attorney withMerrill, Lynch, Pierce, Fenner & Smith, as Vice President-Litigation with Dean Witter Discover & Co., andAssociate General Counsel-Litigation with Interstate Johnson Lane. Between 1989 and 2002, Kern held a numberof litigation and compliance positions with Morgan Stanley, including the position of Senior Vice President–Director of Compliance for its retail operations. RX 5 at 619-622, 697-699 (Ex. A) (Kern Report).310 See Tr. 105:4–108:15 (Enforcement’s Closing Argument); Enforcement’s Post-Hr’g Br. at 88-89.66

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.with the investigation. She learned of the Morgan Stanley investigation after she had formulatedher opinions for this case. 3111. The Firm’s Supervisory StructureThe Firm had 17 staff members located in its single office in New York City. In additionto KL, the staff consisted of three supervisors, three trading desk staff, four brokers, onecorporate finance staff member, and five clerical staff. The Firm’s supervisors had the followingresponsibilities:CK held the position of Executive Vice President and Chief Operating Officer. Sheworked for the Firm for approximately 22 years before she retired in January 2001. One of herprimary responsibilities was the Firm’s corporate finance activity, including its IPO activity. TheFirm’s two other supervisors, JB and LS, reported to her, and she, in turn, reported to KL.JB is the Firm’s Chief Financial Officer and Compliance Director. LS, the Firm’s headtrader, reported to JB.LS became the Firm’s head trader in 1994. The Firm’s three other trading room personnelreported to LS. In addition, LS holds the position of sales supervisor. The Firm’s four otherbrokers reported to LS.Physically, LS, the traders, and the four sales representatives were closely located. LSand the Firm’s three other traders sat facing each other at a four-station desk in a trading room311 Tr. 3728:21-24, 3729:7-10 (Kern). She testified that she has never spoken to anyone at Morgan Stanley about theinvestigation. Tr. 3729:11-13 (Kern).67

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.just 15 feet square. 312 The Firm’s registered representatives had offices just outside the tradingroom, in close proximity to JB’s, CK’s, and KL’s offices. 313Given the Firm’s size and business, its supervisory structure was reasonable. The Firm’sthree supervisors were seasoned securities professionals with just eight staff members under theirsupervision. Each supervisor was active in the day-to-day operations of the Firm. Of particularsignificance, the Panel notes that LS directly participated in, or overheard, conversations thebrokers had with their customers. LS confirmed that none of these conversations ever involvedthe brokers setting commission rates. As Enforcement stipulated, the Firm’s customers alwaysset the commission rates they paid. 314 In addition, LS had frequent contact with all of the Firm’scustomers because they typically called their trades into the trading desk. 315 LS routinely tookcustomer calls himself, which gave him direct knowledge of the Firm’s business.2. The Firm’s Supervision of CommissionsThe Firm’s customers have always set their own commissions, subject to the Firm’scommission policies. Until December 1999, the Firm limited commissions to 5% of the dollarvalue of the trade. 316 Then, in December 1999, the Firm adopted a limit of 3%. 317 JB testified thatthe Firm lowered the limit to 3% at his suggestion because the Firm wanted to maintain aconservative environment. 318 Thereafter, in June 2001, the Firm again modified its commission312 Tr. 1263:11-12 (LS).313 Tr. 1263:19–1265:19 (LS).314 JX 14 at 41 (Joint Stipulations).315 Tr. 1316:19-24 (LS).316 RX 5 at 675 (Kern report).317 JX 14 at 50 (Joint Stipulations).318 Tr. 1554:19-24 (JB). JB observed that the Firm’s clearing firm utilized a 3% guideline.68

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.policy to limit commissions to the lesser of 3% or 20 cents per share. The impetus for this lastmodification was NASD’s investigation that led to the filing of this action. 319 The weightedaverage of the commissions at issue here equaled approximately 1% of the total value of thetrades. 320Pursuant to the Firm’s written supervisory procedures, the Firm’s supervisors reviewedcustomer’s orders, including commissions, appropriately. As Enforcement stipulated, “Customerorder flow, including commissions, was the subject of at least two separate reviews: one by thetrading desk supervisor [LS] and the other by [the Firm]’s Compliance Officer [JB].” 321 LS andJB reviewed all order tickets 322 and the Daily Commission Detail Report (“Trade Blotter”) 323provided by Bear, Stearns Securities Corp. (“Bear Stearns”), the Firm’s clearing firm. The TradeBlotter showed the agency trades executed on the previous day for each registeredrepresentative. 324 The Trade Blotter reported gross commissions only; it did not contain acalculation of the commission rate in cents per share. LS compared the order tickets to the TradeBlotter to ensure there were no discrepancies between the two. 325 He also reviewed the trades toensure that the commissions did not exceed the Firm’s internal guidelines. 326 In addition, CKperiodically reviewed the order tickets as part of her supervisory function. 327319 Tr. 1276:4-19, 1372:14–1373:11 (LS).320 JX 14 at 15, 22 (Joint Stipulations).321 Id. at 78.322 CX 39.323 CX 27. Bear Stearns also provided a similar blotter showing the Firm’s principal trades and over-the-counteractivity, which LS reviewed daily. CX 41.324 JX 14 at 79, 80, 81 (Joint Stipulations).325 Tr. 1278:22–1279:3 (LS).326 Tr. 1279:4-7 (LS).327 Tr. 1291:11-16 (LS).69

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Enforcement does not allege, and there is no evidence, that LS or JB failed to review theorder tickets or the Trade Blotter in accordance with the Firm’s supervisory procedures.Finally, the Firm’s written supervisory procedures required each employee to submit asigned annual certification that they had not shared in the profits or losses of any account of acustomer, or in a transaction with or for a customer during the past year. 328 Without exception,every Firm staff member signed such a certification annually and denied having engaged inprofit sharing.3. The Firm’s Supervision of IPO AllocationsDuring the relevant period, the Firm participated in 110 offerings—57 IPOs and 53secondary offerings. The Firm received relatively small amounts of stock for distribution in theseIPOs. The Firm typically received no more than 1% to 1.5% of any offering. 329 Of the shares theFirm received in any IPO, [it] set aside between 65% and 70% for the house accounts anddivided the balance among its registered representatives, which they in turn allocated amongtheir respective customers. 330JB, LS, and CK reviewed the allocations for compliance with the Firm’s allocationpolicy. 331 For example, JB testified that he reviewed the allocations to be sure they were broadbased. His goal was to ensure that all customers that had indicated an interest in an IPO receivedan allocation. 332328 JX 14 at 75 (Joint Stipulations).329 Tr. 1323:8-10 (LS). Kern calculated the Firm’s weighted average participation in the IPOs at 0.432%. RX 5 at774 (Kern report).330 Tr. 1319:2-13 (LS).331 JX 14 at 84; RX 5 at 682 (Kern report).332 Tr. 1492:5-18 (JB).70

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.In conclusion, the Panel finds that JB, LS, and CK supervised the IPO allocations at issuehere in a manner consistent with the policies and procedures set forth in the Firm’s compliancemanual.IV.CONCLUSIONS OF LAWA. Profit-Sharing ChargeEnforcement argued that the Firm’s receipt of higher-than-normal commissions on orwithin one day of an IPO constituted profit sharing, in violation of Conduct Rule 2330(f). Asdiscussed below, Conduct Rule 2330(f) does not prohibit the receipt of higher commissionsunder the facts and circumstances of this case, and cents per share has never been applied tomeasure the reasonableness of commissions or to determine if a firm is engaged in profit sharing.Accordingly, the Panel finds that Enforcement did not prove by a preponderance of the evidencethat the Firm violated Conduct Rule 2330(f).1. Conduct Rule 2330(f)The Panel’s analysis of the applicability of Conduct Rule 2330(f) to the facts of this casestarts with the rule’s plain language. NASD Conduct Rule 2330(f) provides in pertinent part:Except as provided in paragraph (f)(2) no member or person associated with amember shall share directly or indirectly in the profits or losses in any account ofa customer carried by the member or any other member . . . .The Rule has two core elements. The Rule expresses a prohibition on members or personsassociated with members, who are enjoined not to “share.” And what they are not to share areprofits or losses in any account of a customer carried by a member. Neither element is present inthis case.71

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.(a)Sharing ElementThe plain meaning of “share in” connotes active, intentional conduct quite distinct fromthe passive receipt of commissions shown in this case. Enforcement argued that the term “sharein” also means, “to have a share or part,” as in “shared in the profits.” 333 However, in this sense,the term also connotes active, intentional conduct. “To have a share” connotes that a person hasacquired the right to use or enjoy another’s property, elements that are not alleged in this case. 334To “have” in this sense means “to acquire or get possession of something: OBTAIN.” 335 Here,there is no evidence that the Firm obtained a right to a portion of the profits in any of itscustomers accounts by agreement or otherwise.The Panel concludes that the plain meaning of Rule 2330(f) does not supportEnforcement’s theory. To hold otherwise would result in an illogical construction of the Rule. Ifthe act of sharing does not require an intentional act by the broker, the Rule in essence wouldamount to a prohibition against the receipt of higher-than-typical commissions. However, ifNASD intended the Rule to regulate commission rates, there would have been no need to includethe concepts of “sharing” or “profits” in the Rule.The Panel further concludes that the context of subparagraph (f) of Rule 2330substantiates that the Rule prohibits intentional conduct. As Enforcement’s expert Campbelltestified, the Rule is a “customer protection rule”; 336 it does not exist to discipline brokers for theunilateral acts of customers, but to discipline brokers for doing things that could harm customers.333 AMERICAN HERITAGE DICTIONARY (4 th ed. 2000).334 Id. Other meanings of “share” similarly connote an intentional act. See WEBSTER’S THIRD NEW INT’LDICTIONARY 2087 (1993).335 WEBSTER’S at 1039.336 Tr. 1754:21-1755:2 (Campbell).72

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.The Rule is intended to prevent overreaching by brokers. The other subparagraphs of the Rulebear out this conclusion; each governs the intentional, affirmative conduct of brokers in someway. 337Furthermore, all of the reported cases dealing with profit sharing have looked to thebroker’s intentional conduct in finding a violation. In District Bus. Conduct Comm. v. Amsel, No.C10930016, 1995 NASD Discip. LEXIS 215, at *54 (N.B.C.C. June 26, 1995) (emphasisadded), NASD concluded that a Rule 2330(f) profit-sharing charge must be based upon conductby which “registered individuals seek to share in the profits generated in customer accounts.” InDistrict Bus. Conduct Comm. v. Doshi, No. C10960047, 1999 NASD Discip. LEXIS 6, at *5(N.A.C. Jan. 20, 1999) upon which Enforcement relies heavily, the broker, “admitted that he‘agreed to guarantee his customer … against losses in return for a share in profits.’” Anaudiotape recorded the broker saying to his customer, “okay I am gonna charge you 25% of theprofit [in the account] and the loss is mine. Loss is entirely mine.” 338 The evidence establishedthat the broker knew he was violating the rule: he told the customer that, “because of lawviolation” he could not put the offer in writing, and that the profit-sharing arrangement would beoral “because if letter goes in hands of NSD [sic] I lose license one minute.” 339 In other words,NASD found a quid pro quo.337 Subparagraph (a) prohibits members from making “improper use of a customer’s securities or funds”;subparagraph (b) requires members to adhere to an SEC rule on “possession and control of securities,” and tomaintain “appropriate cash reserves”; subparagraph (c) prevents members from lending customers’ securitieswithout the customer’s “written authorization”; subparagraph (d) bars members from holding customer’s securitiesunless the securities are “segregated” or separately “identified” as the customer’s; subparagraph (e) prohibitsmembers from guaranteeing customers against losses. Subparagraph (f) prohibits members from sharing incustomers’ profits, except under specified circumstances.338 Doshi, No. C10960047, 1999 NASD Discip. LEXIS 6, at *2.339 Id. at *3.73

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.In another case Enforcement relies on, Richard J. Daniello, 50 S.E.C. 42 (1989), theevidence likewise showed that the broker intentionally took a share of the profits in hiscustomer’s account. 340 “Daniello contributed one-half of the initial capital in [the customer’s]account, and received one-half of the profits.” 341 Further, the SEC found that the profits werepaid, not in commissions, but through a series of accounts and cashiers’ checks that the brokerintentionally used to conceal the payments. 342To the same effect is Department of Enforcement v. Reynolds, No. CAF990018, 2001NASD Discip. LEXIS 17 (N.A.C. June 25, 2001), the case Enforcement contends most supportsits theory. There, the National Adjudicatory Council (“NAC”) found that the broker intentionallyshared in a customer’s losses, a fact the broker did not dispute. The account belonged to thebroker’s grandfather, and the broker transferred $200,000 in stock into the account because, inhis words, “I had lost some money in my granddad’s account, and I felt bad and I wanted to putsomething back in it.” 343 The NAC concluded, “A broker who contributes his own assets(whether received as compensation or a loan) because he wants ‘to put something back in’ tooffset trading losses is ‘sharing’ those losses in any sense of the word.” 344 Contrary toEnforcement’s interpretation of Reynolds, the NAC did not premise liability on unintentional andunknowing conduct. 345340 Daniello, 50 S.E.C. at 45 (“It is undisputed that Daniello received a share of profits realized in [the customer’s]account.”).341 Id.342 Id. at 43, 45.343 Reynolds, 2001 NASD Discip. LEXIS 17, at *56.344 Id. at *57.345 Accord, Stephen Michael Sohmer, NYSE Disc. Action 2002-156, 2003 NYSE Disc. Action LEXIS 35, at *16(Apr. 3, 2003) (holding that to be guilty of profit sharing the broker must “knowingly engage[] in a corrupt profitsharingscheme”).74

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Enforcement further cites Reynolds for the proposition that Rule 2330(f) “contains norequirement for an antecedent agreement or for any particular motive.” 346 But the fact that noparticular “antecedent agreement” or “motive” is required does not mean that the Panel candisregard the element of intent. In Reynolds, the broker intentionally established an arrangementto share in the customer losses; to carry out that arrangement, he put assets into an account withthe obvious, undisputed intent of covering losses in that account. There is no evidence of such anarrangement or intent in this case.(b)Profit ElementEnforcement’s argument that it need not prove that customers paid the inflated ratecommission out of actual or realized profits also is not persuasive. Enforcement argues thatlimiting the Rule to mean only “realized” profit “would make its application haphazard anddependent upon the fortuitous timing of the realization event.” 347 In support, Enforcement pointsout that the NASD sanction guideline for violation of the Free-Riding and WithholdingInterpretation provides for the disgorgement of “transaction profits” defined as either “thegreater of the immediate after market unrealized profit (the price determined to be the immediateafter market price times the number of shares minus the public offering price) or the actual profitrealized.” 348 Enforcement also relies on Exchange Act § 21A(f), 15 U.S.C. § 78u-1(f), whichdefines “profit gained” and “loss avoided” for purposes of computing insider trading penalties as“the difference between the purchase or sale price of the security and the value of that security asmeasured by the trading price of the security a reasonable period after public dissemination ofthe nonpublic information.”346 Reynolds, 2001 NASD Discip. 17, at *57.347 Enforcement’s Post-Hr’g Br. at 13, n.50.348 NASD SANCTION GUIDELINES at 25, n.1 (2005).75

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.However, both of the provisions Enforcement cites center on specific transactions, notactivity with respect to a customer’s account. In contrast, although a single transaction mayevidence profit sharing, Conduct Rule 2330(f) specifically prohibits brokers sharing in the“account” of a customer. Campbell testified that the definition of account as used in the Rule didnot refer to “just a select group of transactions.” Rather, it means “the entirety of the account’sactivity.” 349The distinction Campbell noted is significant because Enforcement did not have thenecessary evidence to determine whether the Firm’s customers made or lost money in theiraccounts as a whole. 350 Indeed, without the customers’ prime brokerage accounts, and except forthose transactions involving an immediate flip of IPO shares, Enforcement was not able todetermine if the customers made a profit even at the transaction level. 351The controlling case law confirms the Panel’s interpretation that Conduct Rule 2330(f)addresses realized rather than hypothetical profits. For example, in District Bus. Conduct Comm.v. Amsel, 352 NASD held that the Rule “is intended to address instances where registeredindividuals seek to share in the profits generated in customer accounts.” Without question, thedecision refers to actual as opposed to hypothetical profits. Similarly, in District Bus. ConductComm. v. Doshi, the decision referred to realized profits. The broker had “agreed to guarantee[the customer] against losses in return for a 25 percent share of [the] profits in the [customer’s]349 Tr. 1873:22-1874:13 (Campbell).350 Tr. 1877:15-1878:13 (Campbell).351 Enforcement “does not contend that it is an element … that commissions paid by a customer be traceable to theamount of profit (actual or unrealized) of the customer .…” JX 14 13 (Joint Stipulations).352 1995 NASD Discip. LEXIS 215, at *54.76

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.account,” and “the 25 percent would be paid in cash.” 353 The use of the word “cash” obviouslyrefers to realized profit.Another illustrative case is District Bus. Conduct Comm. v. Davidson, No. LA-4131,1988 WL 858062 (Bd. Govs. Aug. 30, 1988), which held that commissions do not constitute“profits generated in customer accounts” for the purposes of NASD’s profit sharing rule. InDavidson, the respondent had set up a partnership account in which he and his clients had agreedto share profits. The District Business Conduct Committee sanctioned Davidson for violatingArticle III, Section 19(f) of the Rules of Fair Practice, the predecessor to Conduct Rule 2330(f),because it concluded that his receipt of commissions had resulted in his sharing profits in excessof the proportionate share of his contribution to the account. The Board of Governors reversedthe District Committee, stating:[W]e disagree with the District Committee’s interpretation of Article III, Section19(f). Specifically, we do not believe that the commissions that Davidsonreceived in connection with the Alpha account constituted “profits” for purposesof Section 19(f). . . . It is our view that Section 19(f) was not intended to prohibita representative who contributed to an account from receiving agreed-uponcommissions in excess of his proportional share of the account’s trading profits orlosses. 354In short, the foregoing cases make clear that, for a violation to be found, Enforcementmust show that the Firm shared actual profits in its customer accounts, which the evidence failsto establish.353 Doshi, 1999 NASD Discip. LEXIS 6, at *3, *5.354 Davidson, 1988 WL 858062, at *3.77

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.2. Post-Conduct SettlementsEnforcement also relies on two SEC settlements: SEC v. Robertson Stephens, Inc., No.03cv27(RCL) (D.D.C. Jan. 9, 2003) (final judgment accepting settlement) 355 and SEC v. CreditSuisse First Boston Corp., No. 02cv90(RWR) (D.D.C. Jan. 22, 2002) (final judgment ofpermanent injunction and other relief). 356 Enforcement argues that these settlements show that theSEC would view the conduct in this case to violate Conduct Rules 2110 and 2330(f). That is,Enforcement contends that the Panel can rely on the two settlements as evidence of the SEC’sview that “a member firm’s sharing customers’ IPO profits through its receipt of inflatedcommissions violates NASD 2330(f) and 2110.” 357 Enforcement asserts that the Panel shouldgive the settlements great consideration because the SEC authorized the underlying federal courtactions and hence they carry the SEC’s “imprimatur.” 358The Panel finds, however, that the Robertson Stephens and CSFB settlements aredistinguishable on their facts. Therefore, regardless of the appropriate weight to be given to suchsettlements in general, 359 they do not support Enforcement’s contentions in this case.As the Complaints and press releases reveal, Robertson Stephens and CSFB demandedand extracted profit-sharing arrangements and quid pro quos from their customers. 360 Theevidence regarding the Robertson Stephens case shows: (1) Robertson Stephens pressuredcustomers to increase commissions in order to obtain IPO allocations; (2) a Robertson Stephens355 CX 23356 CX 50.357 Enforcement’s Post-Hr’g Br. at 16.358 Id.359 Because the Panel found the Robertson Stephens and CSFB settlements inapposite, the Panel did not reach thelegal issue of whether such settlements have precedential value.360 E.g., CX 23 at 2, 4, 7, 11; CX 50 at 1-2, 4, 8-9; see also Tr. 4315:15–4325:3 (Coffee).78

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.broker told a customer what liquid security to use for a commission-generating offsetting trade;and (3) Robertson Stephens’ management was informed that the firm’s brokers were sharing intheir customers’ profits. Indeed, the Complaint against Robertson Stephens alleges that itsinternal documents showed that Robertson Stephens had imposed actual quid pro quoarrangements on its customers. 361Likewise, the CSFB case involved wrongful demands that customers pay a large portionof their profits to CSFB in order to receive IPO allocations. If customers refused, CSFB deniedthem allocations. Moreover, CSFB’s internal documents showed that CSFB had set ratios for itscustomers. If a customer’s IPO-profit-to-commission ratio was too high, CSFB demanded that itbe reduced. 362 In short, CSFB involved express and coerced profit-sharing deals not present here.The present case involves none of the wrongful conduct present in the RobertsonStephens and CSFB cases.In conclusion, Enforcement did not show by a preponderance of the evidence that theFirm shared in the profits of its customer accounts. Accordingly, the Panel dismisses the firstcause of action.B. Ethics ChargeIn its second cause of action, Enforcement alleged that the Firm violated Conduct Rule2110 by accepting inflated commission payments made by customers to try to influence the Firmto allocate IPO shares to them, independent of whether the payments constituted profit sharing orcontravened generally accepted industry norms. 363 Enforcement argued that the receipt of inflated361 CX 23 at 2, 4, 7, 11.362 CX 50 at 1-2, 4, 8-9.363 Compl. 50.79

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.rate commissions violated Conduct Rule 2110 because they were paid for the customers’improper purpose—to influence the Firm’s allocation of IPO shares. 3641. NASD Conduct Rule 2110NASD Conduct Rule 2110 provides: “A member, in the conduct of his business, shallobserve high standards of commercial honor and just and equitable principles of trade.” Theorigin, purpose, and scope of Rule 2110 rest at the core of self-regulation. Rule 2110’s languageof “just and equitable principles of trade” comes directly from the preamble of the Maloney Act,the 1938 amendment to the Exchange Act that sought to regulate the over-the-counter securitiesmarket. 365 Congress incorporated the Maloney Act into the Exchange Act as Section 15A, whichprovides the authority to create self-regulatory organizations such as NASD. 366The legislative history of the Maloney Act makes clear that its purpose was to respond tothe perceived abuses in the over-the-counter market by establishing a system of self-regulationthat would uphold “just and equitable principles of trade.” In presenting the statute, the SenateCommittee on Banking and Currency identified two alternative avenues to regulation of theover-the-counter market—either an increased role for the SEC or a system of “cooperativeregulation” in which the exercise of supervision would be handled by industry membersthemselves. In a move that heralded the philosophy of self-regulation, the Committeerecommended the latter option—to “enable the people of this business to guide and direct theaffairs of their own industry under governmental supervision. It is intended to provide a way to364 Bill of Particulars at 1–2.365 Pub. L. No. 719, Ch. 677, 52 Stat. 1070, 1070 (1938).366 See generally Tr. 4283:8-17 (Coffee).80

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.prevent acts and practices inconsistent with just and equitable principles of trade … [to affordthe industry] the chance to make their own rules and to impose their own penalties.” 367Thus, from the outset, the concept of “just and equitable principles of trade” wasgrounded in the enforcement of industry norms. 368 The core concept of unethical conduct under“just and equitable principles of trade” has always been the requirement that customers be dealtwith “in accordance with the standards of the profession.” 369 As NASD has underscored, theethical standards imposed by NASD’s Conduct Rules, and particularly Rule 2110, in a broadsense, depend on general rules of fair dealing and marketplace practices. 370 Thus, “[i]f no otherrule has been violated, a violation of Rule 2110 requires evidence that the respondent acted inbad faith or unethically.” 371 Such evidence must establish “misconduct [that] reflects on the[respondent’s] ability to comply with the regulatory requirements of the securities business andto fulfill his fiduciary duties in handling other people’s money.” 372 “The principal considerationis whether the misconduct reflects on an associated person’s ability to comply with regulatory367 See S. REP. NO. 1455, 75th Cong., 3d Sess. 3-4, 7 (1938); see also Tr. 4283:5–4284:16 (Coffee).368 See Statement of Policy of the Director of the Division of Trading and Markets Regarding the Comparability ofNASD and SECO Regulation and the Relevance of Published NASD Standards and Rules of Conduct toNonmember Broker-Dealers and Their Associated Persons, Exchange Act Release No. 9420, 1971 SEC LEXIS245, at *12 (Dec. 20, 1971) (noting that “the evolutionary development of business ethics has occurred through thedisciplinary route where conduct recognized as patently contrary to professional standards has been found, butwhere, for example, the applicable norms previously were not or could not readily be reduced to written rule orguidelines”) (emphasis added).369 Duker & Duker, 6 S.E.C. 386, 388-89 (1939), quoted in Department of Enforcement v. Shvarts, No.CAF980029, 2000 NASD Discip. LEXIS 6, at *24 (N.A.C. June 2, 2000). The SEC has described the “broadethical principle” in “just and equitable principles of trade” to present “the question … whether the member’sconduct in question violates standards of fair dealing.” Samuel B. Franklin & Co., 38 S.E.C. 113, 116 (1957)(reversing NASD discipline for member’s failure to make good delivery of stock).370 See, e.g., Shvarts, 2000 NASD Discip. LEXIS 6, at *12.371 Chris Dinh Hartley, Exchange Act Release No. 50031, 2004 SEC LEXIS 1507, at *10 n.13 (July 16, 2004)(citation omitted).372 Daniel D. Manoff, Exchange Act Release No. 46708, 2002 SEC LEXIS 2684, at *11-12 (Oct. 23, 2002).81

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.requirements necessary to the proper functioning of the securities industry and protection of thepublic.” 3732. Expert TestimonyEnforcement relied on Bogle’s opinion that the Firm’s receipt of inflated ratecommissions was unethical. 374 Bogle testified that the payment of inflated rate commissions was“bribe-like,” and, therefore, manifestly contrary to universally accepted standards of conduct. 375In addition, Bogle considered the practice of allocating new issues to customers who pay manytimes normal commission rates unethical and a violation of NASD Conduct Rule 2110. 376Bogle is a man of exceptional accomplishment and stature. His extraordinaryaccomplishments have been recognized repeatedly. He has received 20 awards and 9 honorarydegrees in recognition of his contributions to the financial services industry and investors. In2004, Time Magazine named him one of the most important and influential people in the world.Throughout his career, Bogle has had an abiding interest in business ethics. He has written andlectured on ethics, and he has assumed a position as one of the mutual fund industry’s greatestcritics. 377 Without question, Bogle’s opinions are worthy of very thoughtful consideration.373 Department of Enforcement v. Davenport, No. C05010017, 2003 NASD Discip. LEXIS 4, at *9 (May 7, 2003).374 Enforcement stipulated that, as of the time of the Complaint, NASD had not specifically stated in any publicationor rule that it was unethical for a member firm to accept inflated commissions from customers who were attemptingto influence the firm to allocate IPO shares to them. JX 14 18.375 Tr. 2437:6-8 (Bogle); CX 31 at 1 (Bogle report).376 CX 31 at 1 (Bogle report).377 Tr. 2435:11-24 (Bogle). On the other hand, Bogle admitted that he is not an expert on NASD’s Conduct Rules oron IPOs. Tr. 2433:3-5, 2465:19-21, 2507:12-17, 2543:14-15 (Bogle).82

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.(a)Commercial Bribery AnalogyThe Panel does not believe that the analogy of the present case to commercial briberywithstands scrutiny. By definition, commercial bribery requires two elements not alleged in thiscase—a quid pro quo agreement (by which the payment is exchanged for a requested act), and abreach of a duty of loyalty owed by the recipient. 378 The second element—breach of fiduciaryduty—is of particular significance because it has been considered the foundation of the offenseof commercial bribery. 379 “[C]ommercial bribery was criminalized on the theoretical premise thatsuch acts represent a violation of the duty of loyalty that an [agent] owes to [a principal].” 380Accordingly, to take the applicable New York statute as an example, the receipt of a bribe occurswhen, without the consent of his employer or principal, [an employee or agent]solicits, accepts or agrees to accept any benefit from another person upon anagreement or understanding that such benefit will influence his conduct inrelation to his employer’s or principal’s affairs …. 381Here, there is no evidence that the Firm breached any fiduciary duty in allocating IPOsduring the relevant period, which Enforcement’s other experts recognized. 382Moreover, Bogle admitted on cross-examination that firms have to allocate shares whenIPOs are hot, and if they do so in their business judgment to their best customers, such practice isethical. 383 Brokers are free to allocate IPO shares in their discretion. As an advisory committee ofNASD and the NYSE stated in 2003, “Unless such an allocation constitutes spinning, an378 See RX 2 at 102-03 (Coffee report).379 Note, Bribery in Commercial Relationships, 45 HARV. L. REV. 1248, 1249 n.10 (1932).380 United States v. Parise, 159 F.3d 790, 799-800 (3d Cir. 1998).381 N.Y. PENAL LAW § 180.08.382 Tr. 1782:14-17 (Campbell); 2186:12-13 (Raha). See also RX 2 at 102-03 (Coffee report); Tr. 3269:19–3270:3(Warther) (not like bribery since “[f]rom an economic perspective there’s been no showing that [the Firm] wasacting as an agent and had a duty to some sort of principal that it violated”).383 Tr. 2492:23–2493:13 (Bogle).83

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.unlawful quid pro quo or other prohibited conduct, the underwriter may allocate IPO shares tocustomers as it chooses”; it may freely allocate “shares to [its] best customers in order tomaintain client relationships.” 384The Panel concludes that the conduct in question here cannot be condemned as unethicalby analogizing it to commercial bribery. As shown above, the commercial bribery label isinapposite. However, this determination does not end the Panel’s inquiry. While Bogle’s opinionrests foremost on his judgment that the payments were tantamount to commercial bribery, healso urges an independent rationale that hinges on a distinction between the nature of thebusiness conducted by “customers” versus “clients.”(b)Customer–Client DichotomyBogle’s testimony was at heart a broad-based criticism of the IPO allocation system.Bogle believes that the securities industry has “lost its way,” and he hoped to speak out in thiscase against the industry’s acceptance of the status quo. 385Bogle starts with the premise that the securities industry should favor “client”relationships over “customer” relationships. Bogle defines the difference as follows:A client … is someone with whom you have a long-term, established relationshipbased on mutual trust. And a customer is someone who goes from place to place,looking for the latest deal. There’s no issue of loyalty. There’s no issue of trust.There’s no issue of trusting or being trusted, in a customer’s sense. And in aclient, those things are everything. 386384 RX 185 at 9865, 9868 (NYSE/NASD IPO ADVISORY COMMITTEE REPORT AND RECOMMENDATIONS 10, 13 (May29, 2003)).385 Tr. 2438:2-19 (Bogle).386 Tr. 2596:22–2597:7 (Bogle). Bogle testified that this was an ethically required distinction. Tr. 2495:2-21(Bogle).84

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.In Bogle’s opinion, because client relationships rest on mutual trust, those relationshipsare inherently more ethical and consistent with the sound functioning of the system of financialmarkets. Thus, Bogle concludes, favoring clients over customers enhances the integrity of thefinancial markets, and the greed associated with “customers” jumping from firm to firm tomaximize their returns from hot new issues undermines investors’ trust. In addition, Boglepostulates that if you generalize the practice of allocating hot new issues to those who lack along-term relationship with their broker-dealer, the result is a chaotic and unethical marketsystem. 387Bogle explained his opinion as follows:[A]ny sound market system depends, finally, upon integrity. Strike a blow at theconfidence of investors and the marketplace is impaired. Allocate new issues, notby fair but by foul means, and the value of trusting and being trusted is debased.When the rules of the game are massaged to enable privileged investors to buytheir way into “free rides” 388 on new issues by paying grossly excessivecommission rates on their regular trades, the market system is abased. 389Bogle’s opinion is more far reaching than Enforcement’s theory in this case. Bogleconsiders troubling all efforts by customers to enhance their relative access to hot new issuesthrough increased commissions, and he considers it antithetical to the sound functioning offinancial markets for broker-dealers to accept this business. For example, Bogle testified that it isimproper for a firm to accept commission rates as low as three cents per share from a mutual387 Tr. 2461:3-11 (Bogle). Bogle bases his opinion in part on Immanual Kant’s “categorical imperative,” whichstates that for ethical conduct “act so that the consequences of your actions can be generalized without selfcontradiction.”See CX 31 at 2 (Bogle report).388 By free ride, Bogle meant that, in the IPO environment of the late 1990’s, profits were just “lying on the table”for purchasers of new issues because there was little or no market risk associated with their purchase. Tr. 2447:9-15(Bogle).389 CX 31 at 2 (Bogle report).85

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.fund that wants IPOs when it could have paid a half a cent. 390 Under Bogle’s paradigm, the key isthe payment of money to influence allocations. He testified that it is unfair for the allocationprocess to be shaped by “extra payments.” 391 The better system, according to Bogle, is to permitfirms to reward their best, long-term clients with hot new issues even if the client, such as amutual fund, intentionally aggregates business to garner increased allocations. 392Bogle’s bottom line is that the IPO allocation system breaks when greedy individuals arewilling to pay higher-than-normal commissions in order to receive certain profits during a crazedIPO market. In his opinion, such unseemly behavior by customers and firms alike tends to erodeinvestor trust in the financial markets and therefore is unethical. Thus, Bogle calls for a totalreform of the IPO allocation system.While Bogle urges improvement in the IPO allocation system to eliminate the greed thatundermines investor confidence, he recognizes that the determination of what an improvedsystem would look like is complicated—much like writing an industry rule, a process that musttake into consideration all competing viewpoints. 393 He personally favors a system wherecustomers pay commission rates of no more than four and one-half cents per share although hesees that such a system would necessarily exclude some from the IPO market while favoringothers (such as the large mutual funds) that can use their buying power to ensure a supply of hot390 Tr. 2479:21-25 (Bogle).391 Tr. 2450:6-12 (Bogle).392 Tr. 2448:21–2449:5, 2459:22–2460:13 (Bogle). Here again, Bogle places a significant degree of importance onthe nature of the relationship between the broker-dealer and its client. For example, Bogle declares it unethical for afirm to allocate shares to a new institutional customer even where the customer had not paid commissions that wereout of the norm although he admits that it is not an easy distinction to articulate. Tr. 2460:14–2461:11 (Bogle). Atanother point, however, he hints that it might be acceptable if the new customer wanted to develop a long-termrelationship. Tr. 2553:5-12 (bogle). In addition, Bogle could not quantify the meaning of “long-term.” Tr. 2463:20–2465:3 (Bogle).393 Tr. 2521:13–2522:7, 2553:19–2554:20, 2560:6–2561:2 (Bogle).86

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.new issues. This resulting inherent bias does not concern Bogle because the surefire IPO profitsare going to those clients that conduct what he defines as “normal” business. 394 On the otherhand, he testified that he is not in a position to proscribe a better system than letting the largemutual funds get all the IPO allocations. 395When Bogle was asked to apply his opinion to industry-accepted practices, he testifiedthat he could not make an ethical determination without knowing the customers’ motives. Forexample, when Bogle was asked about the ethics of a broker accepting a commission of 20 centsper share where the customer told the broker that he knew he could pay four and one-half centsper share, Bogle answered, “if it’s a real bona fide client, I don’t see a particular problem withthat.” 396 In other words, the result depends upon each customer’s intent. Thus, before a firmaccepted a commission, it would have to determine the customer’s intent to avoid violatingConduct Rule 2110. Moreover, in some cases, Bogle admitted that the determination could onlybe made after a review of the customers’ entire transactional history. 397The Firm challenges Bogle’s customer-client dichotomy on several grounds. Apart fromthe fact that Bogle’s definitions are not found in any published guidance, the Firm points out thatEnforcement’s application of the dichotomy is unworkable. The Firm questions Enforcement’spremise that acceptance of otherwise lawful commission payments can be found to violate justand equitable principles of trade where Enforcement concludes that the customer had anunderlying “improper purpose” to “try and influence” IPO allocations. The Firm demonstratesthat application of this new standard would result in a system that permits member firms to394 Tr. 2448:21–2449:5 (Bogle).395 Tr. 2554:8-20 (Bogle).396 Tr. 2584:19-25 (Bogle).397 Tr. 2577:3–2578:4 (Bogle).87

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.allocate IPO shares to their best customers, measured by commission business, but condemns asan improper purpose those payments made by customers to achieve best customer status.Moreover, under this approach, the firm accepting the inflated rate commissions violates Rule2110 despite the fact that it did nothing to induce the payment. Under Bogle’s analysis, the lackof any actual influence is irrelevant. Moreover, because Bogle focuses on the customer’s motive,a violation can occur even if the customer fails in acquiring a larger allotment of IPO shares.In conclusion, for the reasons stated, the Panel dismisses the second cause of action. In sodoing, however, the Panel does not express an opinion on the fairness of the current IPOallocation system. Indeed, Bogle raises a number of probing questions about the manner inwhich the IPO allocation system functions throughout the industry. But that issue is outside thescope of this hearing. Industry reform and standard setting are not functions within the provinceof an NASD hearing panel. 398C. Corporate Finance ChargeThe third cause of action alleges that the Firm failed to file information and documentsrequired by Conduct Rules 2710(b)(1) and (5) for each of the more than 50 IPOs betweenOctober 1999 and March 2000. Specifically, the Complaint alleges that the Firm failed to fileinformation and documents reflecting that it received excessive commissions and engaged inprofit sharing with its customers in connection with IPOs.398 Cf. General Bond & Share Co. v. SEC, 39 F.3d 1451, 1459-60 (10th Cir. 1994) (holding that establishment ofnew standards are “rule changes” that must first be submitted to the SEC for approval under the Exchange Act).88

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.1. NASD Conduct Rule 2710NASD’s Corporate Financing Rule, Conduct Rule 2710, 399 regulates underwriting termsand arrangements. The Rule requires NASD members to file specified documents and otherinformation with NASD before they participate in an IPO or certain other public offerings. 400 TheNASD Corporate Financing Department then reviews the submitted information with anemphasis on the underwriting terms and arrangements, including the underwriters’compensation. 401 The Rule prohibits members from receiving an amount of underwritingcompensation that is unfair or unreasonable, and from underwriting or participating in a publicoffering of securities if the underwriting compensation is unfair or unreasonable. 402The purpose of the Corporate Financing Rule is to ensure that underwriters do not takeadvantage of issuers by charging too much for taking them public. 403 Thus, underwritingcompensation is the focus of the Corporate Financing Department review. 404 The Rule alsoprotects investors because it assures that investor funds are going to be used by the issuers fortheir business plans and are not siphoned off in the underwriting process. 405Conduct Rule 2710(c) defines underwriter compensation by both amount and item.Under Rule 2710(c)(2), members are prohibited—in connection with a public offering—from399 RX 251 (Conduct Rule 2710 (2000)). All references to the Corporate Financing Rule are to the 2000 version,which was in effect during the relevant period. Subsequently, NASD renumbered the Rule without substantivechange to the provisions relevant to this proceeding.400 Conduct Rule 2710(b) governs the filing requirements, and Rule 2710(b)(5) specifies the documents membersparticipating in an offering covered by the Rule must file.401 Tr. 2706:17-23, 2709:17-22 (Price). In contrast, the SEC concentrates its review on the issuer’s management andfinancial statements.402 Conduct Rule 2710(c)(2)(A).403 Tr. 2716:3-16 (Price).404 Tr. 2781:9-13 (Price).405 Tr. 2716:3-16 (Price).89

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.receiving an amount of compensation that is unfair or unreasonable. The Rule further states thatthe amount of compensation is determined by including all items of value 406 received (or to bereceived) by the underwriter or related persons from any source where the items are deemed tobe received “in connection with or related to the distribution pursuant to subparagraphs (3) and(4).” 407 Subparagraph 3 defines “Items of Compensation,” and subparagraph 4 sets out thestandards for determining whether compensation is “received in connection with the offering.”Under the definitional scheme of Conduct Rule 2710(c), the critical inquiry is whetherthe particular item under review can be deemed to be connected or related to the distribution.The Rule addresses this factor both temporally and contextually. As to the former, the Ruleestablishes a presumption that items of value received by the underwriter during the 12-monthperiod immediately preceding the filing of the offering registration statement are relatedsufficiently to the offering so that they are included in the computation of underwritercompensation. 408With respect to the second criterion, context, the Rule directs consideration of a numberof specific factors, as well as other unspecified relevant facts and circumstances. The enumeratedfactors give strong indication of the Rule’s intended reach. First, the Rule directs that theCorporate Financing Department consider the length of elapsed time between the registrationstatement and the receipt of the item under review. Second, the Rule directs the CorporateFinancing Department to consider the nature of the services provided in return for the item ofvalue under review. Third, the Rule directs the Corporate Financing Department to consider the406 “Items of value” is not a defined term under the Rule, but Price testified that it is understood generally to mean“any item that is going to benefit the underwriters.” Tr. 2718:3-9 (Price).407 Conduct Rule 2710(c)(2)(B).408 See Conduct Rule 2710(c)(4)(A).90

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.relationship between the services provided and: (1) the nature of the item of value; (2) thecompensation value of the item; and (3) the proposed public offering. Finally, the Rule directsthe Corporate Financing Department to consider the presence or absence of arm’s lengthbargaining, or the existence of any affiliate relationship between the issuer and the recipient ofthe item of value.2. Expert TestimonyJoseph E. Price (“Price”), 409 the head of NASD’s Corporate Financing Department,testified that—assuming that the Firm was sharing in the profits of its customers—the excessivecommission payments (or inflated rate commission payments) paid by customers on agencytrades of listed securities were underwriting compensation under Rule 2710 because they werepaid to the Firm to influence [its] IPO allocations. 410 On the other hand, Price testified that hewould change his opinion if the Firm had not engaged in profit sharing. 411Price’s expert opinion testimony is critical to the third cause of action because there is noother authority for Enforcement’s theory. Not only has NASD never published any interpretationof the Corporate Financing Rule concluding that all agency commissions paid by customerswithin three business days of an IPO must be reported as possible underwriting compensation, 412but no one has ever done so. 413 In fact, Price had no knowledge of a single underwriter or law409 Price is the Vice President in charge of the NASD Corporate Financing Department. He has headed thedepartment since 1998. Before joining NASD, Price worked for the SEC where he held various positions within theOffice of General Counsel, including Assistant General Counsel with responsibility for issues arising from theDivision of Corporation Finance. He has also been an Adjunct Professor at the Georgetown University Law Schoolwhere he taught securities regulation. See CX 35 (Price report).410 Tr. 2758:6-13 (Price).411 Tr. 2795:5–2796:11 (Price).412 Tr. 4499:3-9 (Price).413 Tr. 4525:10-15 (Price).91

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.firm to an underwriter ever recognizing this disclosure obligation. 414 Frank J. Formica 415(“Formica”), the Firm’s expert on the Corporate Financing Rule, confirmed Price’s statement.Formica testified that commissions of any amount have never been considered to constituteunderwriting compensation. 416 Rather, aftermarket pricing and transactions have been covered bythe NASD Free-Riding and Withholding Interpretation, IM–2110–1 (now Conduct Rule 2790). 417Without proof of profit sharing, the Panel finds no violation of the Corporate FinancingRule. Absent the requisite nexus to an underwriting, the subject commission payments do notconstitute underwriting compensation. The Panel therefore dismisses the third cause of action.D. Books and Records ChargeThe fourth cause of action alleges that the Firm failed to reflect accurately in its booksand records that the Firm shared in its customers’ profits in violation of Section 17(a) of theExchange Act, Rules 17a-3(a)(1), (2), and (6), and NASD Conduct Rules 2110 and 3110. 418Exchange Act Rule 17a-3 requires broker-dealers to make and keep records of all purchases andsales of securities, and of all income and expense and capital accounts; and to make and keepcurrent a memorandum of each brokerage order that shows, among other things, the terms andconditions of the order. 419 In turn, NASD Conduct Rule 3110(a) requires members to comply414 Tr. 2943:15-23 (Price).415 Formica worked at NASD for 30 years. He began his career as an attorney in the Office of General Counsel. In1984 he was appointed Director of the Corporate Financing Department. He held that position until 1990 when hewas appointed Director of NASD’s Congressional and State Liaison Department. Currently Formica serves as aretained consultant in connection with various litigation and arbitration matters, primarily involving NASD rulesand regulatory issues. RX 3 at 125-29 (Formica report).416 RX 3 at 139 (Formica report).417 Id. at 162. Enforcement stipulated that the Firm never violated the Free-Riding and Withholding regulations. JX14 16.418 Compl. 58.419 17 C.F.R. § 240.17a–3(a)(1), (2), and (6).92

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.with Exchange Act Rule 17a-3. Enforcement’s claim is that the Firm should have recorded asprofit-sharing payments the 695 Schedule A-35 transactions that the Firm recorded ascommissions.The Firm contends that it properly booked all of its income. In support, the Firmpresented the expert opinion testimony of Charles R. Lundelius, Jr. (“Lundelius”), 420 anaccountant with FTI Consulting Inc., who reviewed the Firm’s financial statements prepared byits independent auditors, Goldstein Golub Kessler LLP (“GGK”). GGK issued unqualifiedopinions on the Firm’s financial statements, 421 which GGK filed with the SEC pursuant toSection 17(a) of the Exchange Act and Exchange Act Rule 17a-5. 422 The Firm’s financialstatements reflected the commissions at issue under a separate line item specifically denominated“commissions.” 423Lundelius testified that the Firm and GGK properly classified the challenged payments ascommissions and that the commissions could not be accounted for under another incomecategory, such as “profit sharing.” 424 In his opinion, the Firm’s books and records accuratelyrecorded the challenged payments as “commissions” in accordance with generally acceptedaccounting principles (“GAAP”) and generally accepted auditing standards (“GAAS”). 425420 Lundelius is a Senior Managing Director of FTI, a thousand-member financial consulting firm that specializes inrestructuring, forensic accounting, and economic analyses. Tr. 4116:8-11 (Lundelius); RX 7 at 914-16 (Lundeliusreport). He is a Certified Public Accountant with 20 years of experience. He has specialized expertise in financialinstitutions and broker-dealers, and he has experience with running an NASD member firm. In addition, Lundeliusis a member of the NASDAQ Listing Panel. Tr. 4117:23-4119:15 (Lundelius).421 RX 79 at 6026-35; Tr. 1607:2–1608:7 (JB).422 Tr. 1608:3-20 (JB); RX 79 at 6024-6026.423 RX 79 at 6028.424 Tr. 4119:19–4120:9; RX 7 at 911 (Lundelius report).425 Tr. 4128:2-8; 4128:24–4129:8 (Lundelius); RX 7 at 913-14 (Lundelius report).93

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Enforcement, on the other hand, presented no evidence of any irregularities in the Firm’s booksand records apart from its judgment that the inflated rate commission payments were not bonafide commissions and were instead profit-sharing payments.The Panel concludes that Enforcement failed to prove a violation of Section 17(a) of theExchange Act, Exchange Act Rules 17a-3(a)(1), (2), and (6), or NASD Conduct Rules 2110 and3110. The inflated rate commission payments did not constitute profit-sharing payments;therefore, there is no factual basis for Enforcement’s contention that the Firm’s books andrecords were inaccurate. And Enforcement points to no standard requiring a broker-dealer toclassify items of income based on its customers’ intent in doing business with the firm.Accordingly, the Panel dismisses the fourth cause of action.E. Supervision ChargesIn the fifth and sixth causes of action, Enforcement charges that the Firm: (1) failed tofollow up on numerous indications of problems, or “red flags,” regarding profit sharing and theallocations of IPO shares, in violation of Conduct Rules 3010(a) and 2110; and (2) failed toestablish, maintain, and enforce an adequate supervisory system and written supervisoryprocedures regarding the receipt of commissions and the allocation of IPO shares, in violation ofConduct Rules 3010(b) and 2110. 4261. Conduct Rule 3010Conduct Rule 3010(a) requires each member to establish and maintain a supervisorysystem that is reasonably designed to achieve compliance with applicable securities laws and426 The Complaint further charges that these violations constitute violations of Conduct Rule 2110. See, e.g.,Department of Mkt. Regulation. v. Castle Sec. Corp., No. CMS030006, 2005 NASD Discip. LEXIS 2, at *16 n.14(N.A.C. Feb. 14, 2005) (“Any violation of an NASD rule such as … Rule 3010, is also a violation of Conduct Rule2110.”).94

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.rules. Under this Rule, members are required to “set forth the applicable rules and policies thatmust be adhered to and describe specific practices that are prohibited.” 427 The supervisory systemmust be tailored specifically to the member’s business and must address the activities of all of itsregistered representatives and associated persons. 428Conduct Rule 3010(b) requires each member to establish, maintain, and enforce writtensupervisory procedures that are reasonably designed to ensure such compliance. 429 A firm’swritten supervisory procedures memorialize a firm’s supervisory system; they “describe theactual supervisory system established by the firm to achieve compliance with applicable rulesand regulations.” 430 Hence, the written supervisory procedures should include a description of thecontrols and procedures the firm uses to deter and detect improper activity. 431However, the standard set in Conduct Rule 3010 does not require a supervisory systemthat guarantees firm-wide compliance with all laws and regulations. 432 The governing principle isthat the written supervisory procedures must be reasonable under the particular facts andcircumstances of the case at issue. 433 “The duty to exercise reasonable, effective supervision hasnever been construed to be an absolute guarantee against every malfeasance by errantsubordinates.” 434 Nevertheless, when presented with “red flags,” supervisors are obligated to act427 NASD Notice to Members 99-45, 1999 NASD LEXIS 20, at *3 (June 1999).428 Id. at *4.429 Reference to Conduct Rule 3010 is to the version of the Rule in effect in 1999 and 2000.430 NASD Notice to Members 98-96, 1998 NASD LEXIS 121, at *6 (December 1998).431 Id.432 NASD Notice to Members 99-45, 1999 NASD LEXIS 20, at *10.433 See La Jolla Capital Corp., Exchange Act Release No. 41755, 1999 SEC LEXIS 1642, at *13 (Aug. 18, 1999);see also Department of Enforcement v. Lobb, No. C07960105, 2000 NASD Discip. LEXIS 11, at *16 (Apr. 6,2000) (citation omitted).434 Dean Witter Reynolds Inc., Initial Decisions Release No. 179, 2001 SEC LEXIS 99, at *168 (Jan. 22, 2001)(quoting James Harvey Thornton, 53 S.E.C. 1210, 1219 (1999)).95

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.decisively, with appropriate follow-up, to detect and prevent violations of securities laws andrules. 4352. Failure to Supervise ChargeThe fifth cause of action charges that “[Firm] supervisors failed to follow up onnumerous red flags … that [Firm] customers were sharing a portion of their IPO profits with thefirm or that customers were paying inflated commissions to try and influence the firm to allocateIPO shares to them,” and that “[t]hese red flags reasonably should have caused [the Firm’s]supervisors to follow-up and investigate.” 436 The fifth cause of action further charges that theFirm thereby violated Conduct Rules 3010(a) and 2110. 437Here, Enforcement rests liability under the fifth cause of action on Enforcement’sdetermination that the inflated rate commission payments constituted “red flags” of profitsharing, which the Firm’s supervisors ignored. The Panel disagrees with Enforcement’sdetermination and therefore dismisses the fifth cause of action.Enforcement repeatedly stressed that rates far below those specified in the Bill ofParticulars could constitute profit sharing. Enforcement adopted the keystone rate of 20 cents pershare for trades of 10,000 shares or more to filter information in the CSFB investigation. AsOzag testified, he devised the cutoff as a starting point in his analysis of a substantial amount of435 Cf., e.g., Robert Grady, Exchange Act Release No. 41309, 1999 SEC LEXIS 768, at *9 (Apr. 19, 1999) (findingviolation of Section 15(b) of the Exchange Act when respondent failed to follow up on red flag); see also, e.g.,Department of Enforcement v. Levitov, No. CAF970011, 2000 NASD Discip. LEXIS 12, at *26-27 (N.A.C. June28, 2000) (finding supervisory violation under Conduct Rule 3010 when respondent failed to investigate red flags).436 Compl. 60.437 NASD Notice to Members 98-96, 1998 NASD LEXIS 121, at *5. Cf. Dean Witter Reynolds Inc., 2001 SECLEXIS 99, at *178-79 (finding no violation of Section 15(b) of the Exchange Act absent an underlying substantiveviolation).96

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.Indeed, the Panel concludes that a supervisory system that would require supervisors to discerntheir customers’ motivations in setting commissions would be impractical and unreasonable.Further, the Panel notes that the evidence shows that had the Firm made such an inquiry, eachcustomer would have denied a profit-sharing motive. Thus, such an inquiry would have yieldedno evidence of possible misconduct.In addition, there is no evidence of non-compliance with the Firm’s written supervisoryprocedures. 441 Indeed, the evidence shows that the Firm followed its prescribed policies withoutexception. It conducted annual compliance reviews, and each broker signed an annualcertification that he had not engaged in profit sharing. Furthermore, the supervisors revieweddaily the reports they received from Bear Stearns, which reports did not breakout thecommissions on a cents-per-share basis. The Firm reasonably supervised its operations using thereports supplied by Bear Stearns, and at no point did NASD bring a supervisory deficiency to theFirm’s attention. 442In short, commission rates of 20 cents per share or more were not unusual at the Firm orat other firms. Accordingly, the mere receipt of commissions at those rates did not constitute redflags of improper conduct. Therefore, the Panel finds that Enforcement did not prove by apreponderance of the evidence that the Firm failed to supervise its registered representatives.441 Quest Capital Strategies, Inc., Exchange Act Release No. 44935, 2001 SEC LEXIS 2147, at *15 (Oct. 15, 2001)(red flag indicated by violation of existing firm policies through “deliberately flout[ing] the firm’s compliancepolicies”).442 Cf. IFG Network Sec., Inc., Initial Decisions Release No. 273, 2005 SEC LEXIS 335, at *6 (Feb. 10, 2005) (“redflags, such as exception reports, a deficiency letter from Commission staff, and a customer complaint”).98

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.F. Inadequate Supervisory System and Written Procedures ChargeThe Panel finds that the Firm’s written supervisory procedures relative to the issues inthis proceeding were reasonably designed to ensure compliance with applicable securities lawsand regulations, taking into consideration the nature of the Firm’s business. The Firm prohibitednegotiated commissions, quid pro quos involving allocations; 443 tie-ins between commissions andallocations; 444 linkages between allocations and aftermarket purchases of the securities beingdistributed; 445 linkages between allocations and cold offerings; 446 and spinning. 447 These policiesare consistent with generally accepted industry standards.The Firm implemented these policies, among other ways, by requiring all its employeesto certify annually that they had not engaged in profit sharing. In addition, the Firm’s supervisorsreviewed each commission at least twice. Before December 1999, the Firm evaluatedcommissions under NASD’s 5% Policy (IM-2440) and thereafter under its self-imposed, lowerlimits. As to IPOs, the Firm had a minimum of two levels of review for allocations and syndicatefiles. 448Enforcement presented no evidence of any shortcoming in any of the Firm’s writtenpolicies and procedures relative to the charges in the Complaint. Accordingly, the Panel findsthat Enforcement failed to prove by a preponderance of the evidence that the Firm failed tomaintain and enforce an adequate supervisory system and written supervisory procedures.443 Tr. 1620:224–1621:5 (JB).444 Tr. 1621:6-9 (JB).445 Tr. 1621:10-14 (JB).446 Tr. 1621:15-18 (JB).447 Tr. 1545:8-14 (JB); JX 3 at 158; JX 14 16.448 Tr. 1491:5–1492:4 (JB); JX 14 77, 84.99

This Decision has been published by the NASD Office of Hearing Officers and should be cited asOHO Redacted Decision CAF030014.V. ORDERFor the foregoing reasons, the Panel dismisses the Complaint. 449_________________________Andrew H. PerkinsHearing OfficerFor the Extended Hearing Panel449 The Hearing Panel has considered all of the arguments of the Parties. They are rejected or sustained to the extentthey are inconsistent or in accord with the views expressed herein.100

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