Avello, Nicholas T. v. SEC ( 2006 )

In the
United States Court of Appeals
For the Seventh Circuit
____________
No. 05-2850
NICHOLAS T. AVELLO,
Petitioner,
v.
SECURITIES AND EXCHANGE COMMISSION,
Respondent.
____________
Petition for Review of an Order of the
Securities and Exchange Commission.
No. 3-10391r
____________
SUBMITTED MAY 26, 2006—DECIDED MAY 26, 2006
PUBLISHED JULY 21, 2006Œ
____________
Before POSNER, ROVNER, and WILLIAMS, Circuit Judges.
WILLIAMS, Circuit Judge. Nicholas T. Avello is a certified
public accountant who was sanctioned with a letter
of caution by the National Association of Securities Dealers
for submitting inaccurate financial reports. He now peti-
tions for review of an order of the Securities and Exchange
Commission upholding the disciplinary action, arguing that
rules he was held to have violated do not apply to him, and
Œ
This decision was originally released as an unpublished order.
Upon the Commission’s motion, we now issue it as a published
opinion.
2 No. 05-2850
that, even if they do, the standard by which his conduct was
judged was too high. We deny the petition.
I. BACKGROUND
We briefly sketch the regulatory scheme that led the
NASD to focus on Avello. The NASD, a self-regulated
agency registered with the Commission as a national
securities association under the Securities and Exchange
Act of 1934, see 15 U.S.C. § 78o-3(a), adopts rules governing
the conduct of its members and enforces compliance with
federal securities laws and Commission rules and regula-
tions. Otto v. SEC, 253 F.3d 960, 964 (7th Cir. 2001). One
Commission regulation, known as the net capital
rule, requires brokers and dealers to maintain a specified
level of net worth to protect their customers from the firm’s
potential insolvency. See 17 C.F.R. § 240.15c3-1. A firm’s
net worth is determined from books, records, and reports
that the NASD and Commission require members to keep
and submit. See 17 C.F.R. §§ 240.17a-3, 240.17a-5. Depend-
ing on whether the broker or dealer carries or clears
transactions on customer accounts, it is required to submit
either monthly or quarterly reports known as the Financial
and Operational Combined Uniform Single, or FOCUS
reports. 17 C.F.R. § 240.17a-5(a)(2). Under NASD rules, the
title of persons responsible for the accuracy of these reports
is “Limited Principal—Financial and Operations,” otherwise
known as a FINOP. NASD MANUAL, Membership and
Registration Rule 1022(b)(2). A FINOP is “associated with
a member,” and must be a natural person who is registered
with the NASD and has passed a qualifying examination.
Id., Rule 1022(b)(1); NASD MANUAL, Bylaws of the NASD,
Art. 1(dd). A FINOP’s duties include:
(A) final approval and responsibility for the accuracy of
financial reports submitted to any duly established
securities industry regulatory body;
No. 05-2850 3
(B) final preparation of such reports;
(C) supervision of individuals who assist in the prepara-
tion of such reports;
(D) supervision of and responsibility for individuals who
are involved in the actual maintenance of the member’s
books and records from which such reports are derived;
(E) supervision and/or performance of the member’s
responsibilities under all financial responsibility rules
promulgated pursuant to the provisions of the Act;
(F) overall supervision of and responsibility for the
individuals who are involved in the administration and
maintenance of the member’s back office operations; or
(G) any other matter involving the financial and opera-
tional management of the member.
NASD MANUAL, Rule 1022(b)(2).
Avello contracted to work as a FINOP for Hudson Knight
Securities, Inc. (HKS) and remained in that position from
1995 until 1997. During that period the NASD became
aware that HKS was experiencing difficulty meeting its
required level of net capital and began monitoring HKS.
Eventually the NASD determined that the firm had improp-
erly accounted for certain items in its FOCUS reports
which, if properly accounted for, would have shown that the
firm had conducted business while below its required level
of net capital. When the NASD or its Department of
Enforcement believes that an associated person has violated
rules, regulations, or securities laws, it may request
authorization from the Office of Disciplinary Affairs to file
a complaint. Id., Procedural Rule 9211. If alleged to have
violated a statute or certain NASD rules, a respondent may
propose that the NASD’s Chief Hearing Officer select a
Market Regulation Committee Panelist for a Hearing Panel.
Id., Procedural Rule 9221(a)(3). And that’s what happened
here. In 1998 the Department filed a complaint against
4 No. 05-2850
Jonathan Webb, the Chairman and half-owner of HKS, and
Avello (but did not name the firm itself) that was later
vetted before a Hearing Panel.
The complaint alleged ten causes, only three of which
implicated Avello. The charges against Webb alone included
allegations that HKS, acting through him, effected securi-
ties transactions on days when it failed to maintain the
minimum required net capital; failed to maintain the level
of net capital Webb agreed to with the Commission; violated
rules and regulations requiring the accurate maintenance
and submission of books, records, and reports; and con-
ducted business without employing properly qualified
principals required by NASD rules. The causes involving
Avello concerned only the financial reporting obligations;
the complaint alleged that HKS, acting through both Webb
and Avello, had failed to maintain its required level of net
capital, had kept inaccurate books and records, and had
filed inaccurate FOCUS reports. Those causes were based
on the firm’s violation of five rules: Exchange Act Rules
15c3-1, 17a-3, and 17a-5, and NASD Conduct Rules 2110
and 3110. Exchange Act Rule 15c3-1 is the net capital rule.
Rule 17a-3 requires brokers and dealers to keep various
books and records current, while Rule 17a-5 requires them
to file the FOCUS reports. See 17 C.F.R. §§ 240.15c3-1,
240.17a-3, 240.17a-5. NASD Rule 2110 requires members
to “observe high standards of commercial honor and just
and equitable principals of trade,” while Rule 3110 is the
NASD counterpart to the Exchange Act rule regarding the
proper keeping of books and records. The complaint did not
charge Avello with violating NASD Membership and
Registration Rule 1022(b)(2)—the NASD provision specific
to FINOPs.
Before any hearings were conducted, Avello stipulated
that five items were not accounted for properly in HKS’s
books, records, and reports. The first is a debt HKS owed to
American Express for charges incurred by HKS’s officers. At
No. 05-2850 5
the time, Avello believed that the underlying charges were
personal to the officers and thus did not record the unpaid
balance as a firm liability, though he acknowledged that the
account agreement with American Express—which he did
not read until later—made all charges the responsibility of
the firm as well as the individual cardholders. Second is a
$60,000 sole-recourse loan that Avello initially recorded as
a liability, but later removed from HKS’s books on Webb’s
word that it had been paid, even though it had not. The
third item is a lease agreement for office furniture and
equipment. Instead of reading the agreement and recogniz-
ing that the lease should have been capitalized and the
future payments recorded as a liability, Avello treated it as
a rental contract and recorded the monthly payments as
“rent” based on a bank debit memorandum with that
notation. Fourth, Avello included certain receivables,
technically called payment-for-order-flow receivables, owed
to HKS by another broker-dealer as allowable assets on the
firm’s FOCUS reports, even though he stipulated that they
should not have been treated as allowable assets. Finally,
Avello failed to account for debts HKS owed various vendors
and delivery services because the firm would not provide
him with complete and accurate information. When submit-
ting the firm’s FOCUS report to the NASD, Avello high-
lighted these last debts in a letter, stating that he had not
been able to review any of the underlying documents and
was unable to verify the accuracy of the amounts reported.
Avello also stipulated to three more accounting errors
made as a consequence of Webb’s unsuccessful attempt to
increase HKS’s net capital. The first is a $50,000 note
executed by Webb on behalf of HKS that was paid down to
$47,000 by January 1996. Webb never disclosed the note to
Avello, so Avello never recorded it as a firm liability from
late 1995 through 1996 when Webb replaced the note with
a $50,000 revolving line of credit. Avello also booked as
good capital a $65,000 check drawn on Webb’s personal
6 No. 05-2850
checking account and deposited into HKS’s checking
account, even though at the time Avello booked the check
Webb lacked sufficient funds in his checking account to
cover it. Third is a $125,000 account at Smith Barney that
Avello booked as good capital even though it was not
because it was encumbered by a non-HKS officer’s authority
to withdraw funds from the account.
Although Avello stipulated to the improper accounting, he
denied responsibility for the resulting rules violations on
the ground that he had adequately performed his role as
FINOP. The Hearing Panel disagreed and held him liable
for all the accounting errors except those pertaining to the
$50,000 note, the American Express debt, and the $125,000
account at Smith Barney. With respect to the net capital
rule, the Hearing Panel concluded that Avello’s errors made
him responsible for four of the days when HKS conducted
securities transactions while its net capital was below the
required level. The Hearing Panel imposed a $5,000 fine,
$500 in costs, and a 30-day suspension.
A party dissatisfied with a decision of the Hearing Panel
may initiate what becomes a three-step process of appeal.
The first step is an appeal to the National Adjudicatory
Council (NAC). NASD MANUAL, Procedural Rule 9311. The
next is a petition for review by the Commission, 15 U.S.C.
§ 78s(d)(2), and then, if requested, we will review the final
decision of the Commission, 15 U.S.C. § 78y(a)(1).
Avello followed these steps, some more than once. Ini-
tially the NAC held Avello responsible for the same inaccu-
racies that the Hearing Panel did, though it added responsi-
bility for the American Express debt that the Hearing Panel
had been willing to overlook. The NAC confirmed that
Avello was not responsible for the unbooked $50,000 note or
the account at Smith Barney, and further absolved him of
responsibility for misbooking Webb’s $65,000 check because
Avello could not have known the check was no good on the
No. 05-2850 7
date he booked it. The NAC therefore modified the Hearing
Panel’s decision, holding Avello responsible for only one
day’s net capital violation, rather than four, and setting
aside the 30-day suspension. On Avello’s petition for review,
the Commission conducted an independent review of the
record but ultimately agreed with NAC.
Avello then petitioned this court for review of the Commis-
sion’s decision. Before responding to Avello’s brief to this
court, the Commission moved to remand the case, having
discovered an error in the calculation of HKS’s net capital
position on the single date for which Avello was held
responsible. We granted the request. The Commission
remanded the case to the NAC to clarify Avello’s liability for
the net capital violation.
Upon further review the NAC concluded that it mis-
takenly had taken into account the unbooked $50,000 note
for which it had absolved Avello, and that ignoring that
liability he would not be responsible for any net capital
violation. The NAC did not completely exonerate Avello,
however, because it still considered him responsible for
the five accounting errors, though it did reduce the sanction
to a letter of caution, the minimal sanction under NASD
practice for a rules violation, see In re Martin Lee Eng,
Exchange Act Release No. 44224, 2001 WL 427969, at *3
(Apr. 26, 2001). Avello again petitioned for review by the
Commission. His petition raised for the first time additional
arguments related to his recordkeeping and reporting
violations, which the Commission deemed waived because
they could have been raised in the earlier proceedings. The
Commission therefore once again affirmed the findings of
the NAC and sustained the sanction.
II. ANALYSIS
This case has now made its way back to us. Our review is
limited to the Commission’s decision sustaining the NASD’s
8 No. 05-2850
sanctions and we treat the findings of fact as conclusive “if
supported by substantial evidence.” 15 U.S.C. § 78y(a)(4);
see Otto, 253 F.3d at 964. Avello’s brief lists some ten
issues, but we think he makes two principal arguments.
His first is that Exchange Act Rules 17a-3 and 17a-5 do
not apply to him because those rules literally apply to
brokers or dealers, not to FINOPs. He is correct that
Exchange Act Rules 17a-3 and 17a-5, “by their terms, apply
to broker-dealers, not to persons associated with broker-
dealers.” Davrey Fin. Servs. Inc., Exchange Act Release No.
51780, 2005 WL 1323032, at *4 n.13 (June 2, 2005) (naming
Rules 17a-3 and 17a-4, but analysis is applicable to Rule
17a-5 because it too is limited to broker-dealers). Indeed, in
its brief the Commission concedes that HKS, not Avello,
violated the regulations. And in its decisions the Commis-
sion often attributes the violation of a rule to the securities
firm while characterizing the limited principal as responsi-
ble for the firm’s violations. See id.; In re William H.
Gerhauser, Exchange Act Release No. 40639, 53 S.E.C. 933,
938-40 (Nov. 4, 1998) (discussing net capital requirement as
firm’s obligation); In re Gilad J. Gevaryahu, Exchange Act
Release No. 33038, 51 S.E.C. 710, 710 (Oct. 12, 1993)
(referring to FINOP as “responsible for the firm’s failure to
comply” with net capital, recordkeeping, and reporting
requirements); In re George Lockwood Freeland, Exchange
Act Release No. 34-32192, 51 S.E.C. 389, 390 (Apr. 22,
1993) (same).
But Avello could violate Exchange Act rules indirectly
through NASD Membership Rule 1022(b). That rule, akin
to an accomplice-liability statute, incorporates violations of
other provisions. If Avello, as the FINOP, caused HKS to
violate an Exchange Act rule by maintaining inac-
curate records or submitting inaccurate reports, then he
is responsible for the Exchange Act violation. Thus, because
HKS violated Exchange Act recordkeeping and reporting
No. 05-2850 9
rules, Avello was responsible for the violations under Rule
1022(b)(2).
Avello counters that he was never charged with violat-
ing Rule 1022(b) and so to hold him liable for violating
it contravenes the procedural safeguards prescribed by
15 U.S.C. § 78o-3(h)(1). True, the underlying complaint does
not reference Rule 1022(b), but Avello has not explained
how that omission has prejudiced him. See Rehman v.
Gonzales, 441 F.3d 506, 509 (7th Cir. 2006) (explaining in
immigration context that reviewing court will not set aside
agency decision on basis of claimed procedural error unless
mistake or error caused prejudice). Nor do we see how it
could have; the Hearing Panel first put him on notice of the
application of Rule 1022(b)(2) in 1999, yet Avello waited to
argue that he lacked notice of that rule until five years and
four rounds of review later. Anyway, the language of the
complaint, alleging that HKS violated the rules through
Avello, was enough to alert him to the NASD’s theory of
liability.
We turn then to his second main argument. Avello argues
that even if Rule 1022(b)(2) applies to him, he was held to
too high a standard under that rule. He asserts that he has
effectively been held to a standard of “strict liability” for
guaranteeing the accuracy of the firm’s reports when he
was simply “the hired hand used to perform the Firm’s net
capital calculations.” He suggests that a reasonableness
standard should govern and that his conduct should be
compared to what reasonable accountants (though we
suspect he means bookkeepers)—not auditors—do. The
Commission does not articulate a precise standard; in its
brief the Commission emphasizes the plain language of
Rule 1022(b)(2) making a FINOP responsible both for the
accuracy of the firm’s FOCUS reports and for supervising
the persons who generate the records underlying the
reports, but the Commission does not argue that Avello
could have been sanctioned for inaccuracies about which he
10 No. 05-2850
did not know and could not have known. Indeed, the
Commission points out that Avello was disciplined because
he booked information that he either knew to be incorrect
or with reasonable inquiry would have discovered to be
incorrect.
We need not decide, then, whether the Commission
could adopt or enforce a standard making a FINOP strictly
liable for inaccuracies in a firm’s FOCUS reports or the
underlying documentation. Avello himself proposes that
liability should attach for unreasonable conduct, and there
is substantial evidence to support that Avello acted unrea-
sonably in accounting for the American Express bills, the
sole-recourse loan, the lease agreement for office furniture
and equipment, the receivables owed to HKS, and the
vendor and delivery service debts. With respect to the
American Express debt, the account agreement HKS had
with American Express stated that the charges were the
responsibility of the company as well as the individual;
Avello should have looked at the agreement to determine
whose responsibility the charges were, especially when he
discovered that the individual cardholders had been in
default on their payments for several months. There is no
explanation for Avello’s failure to continue booking the sole-
recourse loan as a liability; he had booked it as a liability
for several months in 1996 but then failed to book it as a
liability thereafter based on (what turned out to be a false)
representation by Webb that it had been paid. As for
Avello’s failure to capitalize the furniture lease and book
the overall liability rather than show the monthly payments
as rent, he admitted that he booked the lease as he did
based on a bank debit memo and that he would have
recorded it correctly had he taken the time to look at the
lease itself. Given that a FINOP must examine the underly-
ing documentation before classifying an item, see
Gerhauser, 53 S.E.C. at 947 n.40, we find no fault with the
Commission’s determination that these were errors for
which Avello was responsible.
No. 05-2850 11
Likewise, the Commission’s determination that Avello
bore responsibility for two other inaccuracies is sup-
ported by the record. Avello had been twice informed by
NASD staff that the receivables were not the type that
could have been booked as allowable assets for purposes of
the firm’s net capital calculation. Yet for the following four
months he continued to book them as allowable assets.
Finally, Avello admitted that, despite knowing he was not
getting complete and accurate information from HKS
regarding various debts owed to vendors and delivery
services, he nevertheless submitted FOCUS reports that did
not include the debts as liabilities. Although he informed
the NASD by letter that he was unsure of the report’s
inaccuracy, he essentially violated one rule (requiring
accurate reports) to save the firm from violating another
(requiring quarterly reports). But if Avello found himself
unable to discharge his duties as FINOP, the proper course
was for him to resign, not to file reports with attached
caveats. See Freeland, 51 S.E.C. at 392. Thus, there was
substantial evidence to support the Commission’s determi-
nation that Avello failed to satisfy his duties as a FINOP in
these five instances.
Avello’s remaining arguments for a different standard
do not convince us to alter our view. That he disclaimed
responsibility for the accuracy of the firm’s books and
records in an engagement letter with HKS matters not; one
cannot contract out of statutory duties. See U.S. Sec.
Clearing Corp., Exchange Act Release No. 35066, 52 S.E.C.
92, 98 n.30 (Dec. 8, 1994). Nor are we persuaded that the
fact that he worked only four hours a month for HKS calls
for absolving him of liability. See Gevaryahu, 51 S.E.C. at
712-13. His policy argument that smaller firms will not
be able to afford FINOPs who perform the duties as dili-
gently as required by NASD rules is irrelevant but, regard-
less, has no support in this record. All we know is that
Avello and HKS came to an agreement about how he was to
12 No. 05-2850
be compensated, and that in retrospect Avello believes the
contract price was too little for what the NASD expected of
him. Finally, despite his contention that a FINOP ought to
be treated as someone who simply compiles numbers,
rather than as an auditor, the requirements of a FINOP are
different than those of a bookkeeper. The position of a
FINOP is unique and governed solely by NASD rules. So
even though auditors examine underlying documents, the
Commission has decided that a FINOP should do so as well.
See Gerhauser, 53 S.E.C. at 947 n.40; In re James S.
Pritula, Exchange Act Release No. 40647, 53 S.E.C. 968,
972 (Nov. 9, 1998) (explaining that FINOP should have
ascertained whether check had been deposited before
treating it as asset).
Avello’s other arguments merit little discussion. He
argues that he could not have violated NASD Conduct
Rule 2110 because the Commission did not find that he
acted in bad faith. (As with the Exchange Act rules, Avello
is liable for the firm’s violation of Rule 2110 only through
Rule 1022 because Rule 2110 applies to “members,” which
Avello was not.) But the Commission does not require a
finding of bad faith when the predicate for violating Rule
2110 is the violation of another NASD or Exchange Act rule,
see In re Chris Dinh Hartley, Exchange Act Release No.
50031, 2004 SEC LEXIS 1507, at *10 n.13 (July 16, 2004);
Gerhauser, 53 S.E.C. at 942, and we have already explained
that substantial evidence supports that Avello was respon-
sible for other violations. Avello’s arguments that the
Commission was required to find that he “controlled” a
person who committed a violation under 15 U.S.C. § 78t(a)
or that he acted “willfully” under 15 U.S.C. § 78o(b)(4) were
not presented until his return to the Commission after
remand and are accordingly waived. See United States v.
Parker, 101 F.3d 527, 528 (7th Cir. 1996) (“A party cannot
use the accident of a remand to raise in a second appeal an
issue that he could just as well have raised in the first
No. 05-2850 13
appeal because the remand did not affect it.”); W. Va. v.
EPA, 362 F.3d 861, 871 (D.C. Cir. 2004) (refusing to
consider arguments raised for first time after remand that
were not raised in agency rulemaking proceedings con-
ducted prior to remand). His argument that he is not
responsible for HKS’s reports because they were submitted
by his corporation and not signed by him is frivolous
because a FINOP, as a “person associated with a member”
is, by definition, a natural person. See NASD MANUAL,
Bylaws of the NASD, Art. 1(dd).
We note that the various agency decisions recognize
Avello’s good-faith efforts at accurate financial reporting.
But those efforts do not excuse his failure to comply
with the duties of a FINOP, and that failure justifies the
lenient sanction upheld by the Commission. We therefore
DENY the petition for review.
A true Copy:
Teste:
________________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—7-21-06