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Three FINRA AWCs and One Mess of an Arbitration Raise Unanswered Questions About Supervision
June 1, 2021
A recent FINRA regulatory settlement sanctioned a supervisor's alleged failure to "restrict" a trader's "market access." But as the facts emerged, that trader didn't exactly follow compliance policies and engaged in subterfuge to hide his tracks and cover up his trades. All of which raises questions as to whether the supervisor was victimized by the trader and an over zealous regulator. Unfortunately, there just doesn't seem to be a satisfactory answer to that seminal question, which leaves the supervisor in an uncomfortable posture.
Reynolds 2015 AWC
For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, Scott Richard Reynolds submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of Scott Richard Reynolds, Respondent (FINRA AWC 2017054411901 / May 4, 2015)
https://www.finra.org/sites/default/files/fda_documents/2017054411901
%20Scott%20Richard%20Reynolds%20CRD%202705340%20AWC%20rr.pdf
%20Scott%20Richard%20Reynolds%20CRD%202705340%20AWC%20rr.pdf
The AWC alleges that Scott Richard Reynolds was registered with Spartan Securities Group, Ltd. since February 2005. The AWC alleges under "Relevant Disciplinary History" that Reynolds "has no disciplinary history." During the review period of August 1, 2009 through August 1, 2011, the AWC asserts that Reynolds:
failed to disclose an outside brokerage account to his employer, a FINRA member. The conduct in this paragraph constitutes a violation of FINRA Rule 2010 and NASD Rule 3050.
In accordance with the terms of the AWC, FINRA imposed upon Reynolds a Censure and $10,000 fine.
Reynolds 2021 AWC
For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, Scott Richard Reynolds submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of Scott Richard Reynolds, Respondent (FINRA AWC 2017054411901 / March 25, 2021)
https://www.finra.org/sites/default/files/fda_documents/2017054411901
%20Scott%20Richard%20Reynolds%20CRD%202705340%20AWC%20rr.pdf
The AWC alleges that Scott Richard Reynolds was first registered in 1996, and was registered with Spartan Securities Group, Ltd. from February 2005 until March 2019. As set forth in the "Overview" of the 2021 AWC:
From January 3, 2017 through February 28, 2019, Reynolds executed 580 non-bona fide matched trades between his proprietary inventory account at Spartan and six outside brokerage accounts that Reynolds controlled in a relative's name. Reynolds executed the trades so that it would appear to Spartan's clearing firm the he was a net purchaser and the clearing firm would not purchase shares on Spartan's behalf (i.e., conduct a "buy-in") pursuant to its regulatory obligation to close-out fails-to-deliver within the timeframe required by Rule 204 of Securities and Exchange Commission Regulation SHO ("Rule 204").1 In addition, Reynolds executed 507 matched trades between his Spartan account and his accounts to compensate an account that lost money as a result of price changes in the matched trades he executed to avoid a buy-in. As a result, Reynolds violated FINRA Rules 5210 and 2010.
Between 2014 and February 28, 2019, Reynolds failed to disclose the six brokerage accounts to Spartan even though he traded in those accounts at his own discretion; and he failed to disclose his association with Spartan to the firms where his accounts were held. As a result, Reynolds violated NASD Rule 3050(c) (for conduct prior to April 3, 2017), FINRA Rule 3210 (for conduct on or after April 3, 2017), and FINRA Rule 2010.
Finally, on one occasion, Reynolds impersonated his relative in a telephone call with a brokerage firm where the relative held one of the six accounts. As a result, Reynolds violated FINRA Rule 2010.
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Footnote 1: Reynolds executed short sales in his Spartan account as a registered market maker. Rule 204(a)(3) of Regulation SHO, promulgated pursuant to the Securities Exchange Act of 1934, provides that "[i]f a participant of a registered clearing agency has a fail to deliver position at a registered clearing agency in any equity security that is attributable to bona fide market making activities by a registered market maker . . . the participant shall by no later than the beginning of regular trading hours on the third consecutive day following the settlement date, immediately close out the fail to deliver position by purchasing or borrowing securities of like kind and quantity."
In accordance with the terms of the 2021 AWC, FINRA found that Reynolds violated NASD Rules 3050(c), and FINRA Rules 5210, 3210, and 2010. Accordingly, the self-regulatory-organization imposed upon Reynolds a $60,000 fine, and an 18-month suspension from associating with any FINRA member in any capacity.
Lopez 2021 AWC
For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, David Daniel Lopez submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of David Daniel Lopez, Respondent (FINRA AWC 2019060701001 / May 19, 2021)
https://www.finra.org/sites/default/files/fda_documents/2019060701001
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The AWC alleges that David Daniel Lopez entered the industry in 1995, and he was registered with Spartan Securities Group, Ltd. from 2001 until June 2019. The AWC alleges that Lopez "does not have any relevant disciplinary history." As set forth under "Facts and Violative Conduct" in the AWC:
The AWC alleges in part that:This matter originated from a notice FINRA received on March 7, 2019. that Spartan had had [sic] ceased business operations due to net capital deficiencies that had been caused by a firm trader.
On March 6, 2019, the trader executed a series of transactions in Spartan's proprietary account that resulted in short positions in a biotechnology stock that exceeded the trading limits set forth in the firm's WSPs. Lopez became aware of the short positions in the biotechnology stock in the morning on March 6, 2019, but failed to modify or restrict the trader's market access until close to the end of the trading day. On March 7, 2019, by the time Spartan was able to cover the short positions into which the former trader had entered, the firm suffered a loss of approximately $16.6 million.
Further, the AWC alleges that during the relevant period of January 1, 2018 through March 6, 2019:
[L]opez was Spartan's designated principal responsible for supervising all firm traders, as well as trading and market making at the firm. These responsibilities included establishing, documenting, and maintaining a system of risk management controls and WSPs reasonably designed to achieve compliance with the Market Access Rule. During the same time period, the firm provided market access to the trader through the firm's execution management system, which the trader regularly utilized to route quotes and orders to the market.
In accordance with the terms of the AWC, FINRA found that Lopez violated FINRA Rules 3110 and 2010; and imposed upon him a 12-month suspension from associating with any FINRA member in all Principal capacities -- in light of his financial status, no monetary sanctions were imposed.
Spartan v. Reynolds 2021 FINRA Arbitration Award
In a FINRA Arbitration Statement of Claim filed in April 2019, FINRA member firm Claimant Spartan Securities alleged breach of fiduciary
duty; fraudulent misrepresentation; negligent misrepresentation; and breach of contract. Claimant Spartan Securities sought in excess of $16.6 million in compensatory/consequential damages, punitive and exemplary damages, costs, and interest. In the Matter of the Arbitration Between Spartan Securities Group, Ltd., Claimant, v. Scott Richard Reynolds, Respondent, v. Axos Clearing LLC and Gregory Garrabrants, Third-Party Respondents and SRR Fortress Capital, LLC, Fourth-Party Respondent (FINRA Arbitration award 19-00926 / May 27. 2021)
https://www.finra.org/sites/default/files/aao_documents/19-00926.pdf. As set forth in part in the FINRA Award:
[T]he causes of action relate to short positions in Biopath Holdings, Inc. taken by Respondent Reynolds in Claimant's proprietary account held at Third Party Respondent Axos that allegedly violated Claimant's policy and the limitations and restrictions on Respondent Reynolds' trading authorization in that account, and resulted in a violation by Claimant of its net capital requirements.
Reynolds' Counterclaim
Respondent Reynolds generally denied the allegations, asserted various affirmative defenses, and filed a Counterclaim against Claimant Spartan asserting common law indemnification; contractual indemnification; failure to pay earned wages; and promissory note due and owing. The FINRA Arbitration Award asserts that the causes of action in Reynold's Counterclaim relate in part to:
[R]eynolds' potential liability in connection with the Clearing Agreement between Claimant and Third Party Respondent Axos dated April 18, 2013 ("Clearing Agreement"), Claimant's alleged failure to pay earned wages to Respondent Reynolds, and Claimant's alleged failure to pay Respondent Reynolds sums due under the terms of a promissory note between Connect X Capital Markets, LLC, a holding company of Claimant, and Respondent Reynolds (the "Note").
Reynolds' Third-Party Claim Against Garrabrants
In addition to filing a Counterclaim, Reynolds filed a Third-Party Claim against Respondent Garrabrants asserting fraud in the inducement and duress. The FINRA Arbitration Award asserts that the causes of action in the Third-Party Claim relate to:
[T]hird Party Respondent Garrabrants' alleged use of intimidation to induce Respondent Reynolds to sign a document entitled "settlement agreement" with Third Party Respondent Axos dated March 8, 2019 ("Settlement Agreement") that did not include some of the key elements of the verbally negotiated settlement during a three-way telephonic conference between Claimant's Chief Compliance Officer, Respondent Reynolds (on his own behalf and on behalf of Fourth Party Respondent SRR) and Third Party Respondent Garrabrants (on his own behalf and on behalf of Third Party Respondent Axos).
Reynolds' Third-Party Claim Against Axos
[R]espondent Reynolds' potential liability in connection with the Clearing Agreement and the alleged fraud utilized to entice Respondent Reynolds to sign the Settlement Agreement.
Axos' Counterclaim
Not content to merely parry Reynold's claims, Respondent Axos filed a Counterclaim against him asserting breach of the Settlement Agreement; fraudulent inducement;
fraudulent misrepresentation; negligent misrepresentation; fraudulent failure to disclose; tortious
interference with contractual relations; breach of an agreement (the "Pledge Agreement") in
which Respondent Reynolds promised to pledge assets in an account held by Respondent
Reynolds and Fourth Party Respondent SRR at TD Ameritrade in favor of Third Party
Respondent Axos, in order to rectify the losses Respondent Reynolds caused; and unjust
enrichment.
Axos' Fourth-Party Claim Against SRR
In addition to filing a Counterclaim against Reynolds, Axos filed a Fourth Party Claim against SRR asserting breach of the Settlement Agreement; breach of the Pledge Agreement in which Respondent Reynolds promised to pledge assets in an account held by Respondent Reynolds and Fourth Party Respondent SRR at TD Ameritrade in favor of Third Party Respondent Axos, in order to rectify the losses Respondent Reynolds caused; and unjust enrichment.
Parties Clarify Their Damages
Understandably, the FINRA arbitrators may have found themselves confused and somewhat overwhelmed by the various claims and demands for damages. In May 2021, the following clarifications were offered:
In its May 7, 2021 submission requested by the Panel, Claimant clarified its damage request against Respondent Reynolds as follows: $16,557,523.70 in trading losses; $5 million representing the destruction of its business which was planned to continue to operate for another 15-20 years; punitive damages in the amount of the lesser of an additional $5 million dollars or three times the amount of compensatory damages awarded; interest; and costs.In his May 7, 2021 submission requested by the Panel, Respondent Reynolds clarified his damage requests as follows:Against Claimant:$1,400,000.00 for Claimant's Failure to Pay Earned Wages; $675,000.00 for amounts due under the Note; $3,100,000.00 in legal fees; indemnification of $16,000,000.00 if Respondent Reynolds is found liable for Claimant's account deficiency; and indemnification of $11,000,000.00 if Respondent Reynolds is found liable under the Settlement Agreement.Against Third Party Respondent Axos:$10,500,000.00 in compensatory damages and $3,075,000.00 in legal fees.Against Third Party Respondent Garrabrants: $10,500,000.00 in compensatory damages.Against Claimant and Third Party Respondents Axos and Garrabrants, jointly and severally: $9,400,000.00 in punitive damages.In its May 7, 2021 submission requested by the Panel, Third Party Respondent Axos clarified its damage requests as follows:Against Respondent Reynolds: $15,393,598.93 in compensatory damages based on fraud ("Fraud Damages"); interest through May 12, 2021 in the amount of $2,038,873.70; and additional interest per diem in the amount of $1,817.71 from May 13, 2021 through payment of the Award; or alternatively, $5,602,99.19 in compensatory damages (the difference between Fraud and Contract Damages, as Contract Damages is defined hereinbelow), and additional interest per diem in the amount of $521.13 until the Award is paid in full. Third Party Respondent Axos further requests punitive damages at the discretion of the Panel, and assessment of all hearing session fees against Respondent Reynolds.Against Respondent Reynolds and Third Party Respondent SRR, jointly and severally: $10,500,000.00 in compensatory damages based on breach of the Settlement Agreement ("Contract Damages"); interest through May 12, 2021 in the amount of $1,320,493.44; additional interest per diem in the amount of $1,296.58 from May 13, 2021 through payment of the Award; and assessment of all hearing session fees jointly and severally against Respondent Reynolds and Fourth Party Respondent SRR.
Motion Practice
As might be expected, starting in September 2019 and running through May 2021, the parties engaged in robust motion practice, which featured among other things, efforts to stay the arbitration and compel discovery production, demands for sanctions, and a request to conduct evidentiary hearings "virtually" rather than in person. Notably, the Panel conducted the evidentiary hearings virtually and agreed to provide an "Explained Decision" in response to the parties' Joint Request for same.
Award
The FINRA Arbitration Panel found Respondent Reynolds "solely responsible for the losses suffered by Claimant Spartan and Third Party Respondent Axos. In rendering that finding, the Panel offered, in part, this rationale:
The witnesses called by Spartan and Axos were credible and Reynolds' testimony was not. Moreover, the evidence of unambiguous text messages, created contemporaneously with the occurrence of operative events were highly probative, especially when compared to contradictory testimony proffered by Reynolds.Reynolds, a licensed securities professional, initiated the short sale position in BPTH on or about March 6, 2019, creating an open-ended risk of loss to Spartan/Axos. Primarily using Axos' money and being aware of Axos' lending limits and its right to reject trades and close trading positions, he was caught in a short squeeze, causing Spartan to violate its net capital requirement, which as a member of FINRA, it self-reported.As a licensed individual, trading through a FINRA member firm's proprietary account, Reynolds had no discretion to disregard the explicit directives of Spartan's compliance officer to cover the BPTH short on March 6, 2019 and in fact, exacerbated the highly risky short position by adding to it, in contravention of his supervisor's instructions and his own trading limits.The Panel finds that Reynolds' unlawful actions were not merely negligent or reckless, but intentional. This is evidenced by numerous acts such as fictitious trade entries made by Reynolds into Spartan's control/Brass system in order to make it appear as if the BPTH short position was materially smaller than the true amount. Reynolds' explanation for these 'wooden' tickets defied common sense. His further assurances that there was a 'block-order' or big seller coming in late on March 6 was likewise false. These actions/representations, among others, caused both Spartan and Axos to reasonably rely to their detriment. Reynolds did not want to close out the short position on March 6 despite orders to do so by his employer. He lied to keep it open and concealed his intent from Spartan/Axos. Those two entities reasonably relied, suffering large losses, including the destruction of Spartan's on-going business.Spartan's/Axos' covering of the short position in BPTH on March 7, 2019 was proper as they attempted to mitigate the loss while constricted by the existence of Spartan's net capital violation.Reynolds traded mainly with Spartan's and Axos' funds, assuming the risk of his conduct, by virtue of his agreement with Spartan to absorb trading losses which exceeded his accumulated reserves. This was clearly evidenced by writings, oral agreement(s) and course of dealings.
The Panel found Reynolds liable for fraudulent misrepresentation, breach of fiduciary duty, and breach of oral contract, and ordered him to pay to Claimant Sparta $1,421,296.34 in compensatory damages plus interest; and $4 million in punitive damages attendant to his:
willful and intentional behavior on March 6, 2019, disregarding Claimant Spartan's compliance officer's directives to cover the short position in BPTH, and creating false tickets to hide the true size of the short position. Such actions led directly to Claimant Spartan's financial collapse as an ongoing business. Claimant Spartan proved this by clear and convincing evidence.
In response to Axos' Counterclaim, the Panel found Reynolds liable for fraudulent misrepresentation and fraudulent failure to disclose, and ordered him to pay to Axos $15,393,598.93 in compensatory damages plus $17,436,108.05 in interest.
The Panel denied Axos claims against SRR.
The Panel assesed $63,850 in hearing fees solely against Reynolds.
Bill Singer's Comment
Compliments to the FINRA Arbitration Panel for producing a comprehensive Award replete with content and context.
One troubling aspect of Reynolds' conduct is noted in the yellow-highlighted portion of the FINRA Arbitration Award above. Three independent arbitrators pointed found
[R]eynolds did not want to close out the short position on March 6 despite orders to do so by his employer. He lied to keep it open and concealed his intent from Spartan/Axos. . . .
If, in fact, Lopez had directed Reynolds to cover the short, and, Reynolds fabricated tickets and otherwise lied in an effort to deceive Lopez, then it would seem that Lopez was also victimized by Reynolds' ongoing fraud. As such, this assertion in the Lopez AWC seems disconnected from reality:
Lopez became aware of the short positions in the biotechnology stock in the morning on March 6, 2019, but failed to modify or restrict the trader's market access until close to the end of the trading day.
It may be that Lopez AWC focused on the supervisor's literal failure to "restrict" Reynolds' "market access" in contradistinction to merely ordering Reynolds to "cover" his shorts. On the other hand, even the AWC concedes that Lopez only first "became aware of the short positions . . . in the morning on March 6, 2019 . . . " The Lopez AWC should have made some effort to connect the dots.
Notwithstanding my reservations about the Lopez AWC, I acknowledge that it is a regulatory settlement, that Lopez voluntarily entered into same, and that he consented to the findings and the imposition of sanctions. To that extent, my questions about FINRA's contentions are merely academic musings. Regardless, FINRA does have some obligation when charging a supervisor to make out a better case as to what he knew, when he knew it, and how the supervisor's conduct under said circumstances failed to comply with his obligations to reasonably supervise. It may be that FINRA's allegations against Lopez are spot-on; however, I see allegations and conclusions but far too much daylight between the two.