[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
ONE BROKER GONE BAD:
PUNISHING THE CRIMINAL,
MAKING VICTIMS WHOLE
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
OVERSIGHT AND INVESTIGATIONS
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
MAY 23, 2002
__________
Printed for the use of the Committee on Financial Services
Serial No. 107-71
U. S. GOVERNMENT PRINTING OFFICE
82-396 WASHINGTON : 2002
___________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512-1800
Fax: (202) 512-2250 Mail: Stop SSOP, Washington, DC 20402-0001
HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa JOHN J. LaFALCE, New York
MARGE ROUKEMA, New Jersey, Vice BARNEY FRANK, Massachusetts
Chair PAUL E. KANJORSKI, Pennsylvania
DOUG BEREUTER, Nebraska MAXINE WATERS, California
RICHARD H. BAKER, Louisiana CAROLYN B. MALONEY, New York
SPENCER BACHUS, Alabama LUIS V. GUTIERREZ, Illinois
MICHAEL N. CASTLE, Delaware NYDIA M. VELAZQUEZ, New York
PETER T. KING, New York MELVIN L. WATT, North Carolina
EDWARD R. ROYCE, California GARY L. ACKERMAN, New York
FRANK D. LUCAS, Oklahoma KEN BENTSEN, Texas
ROBERT W. NEY, Texas JAMES H. MALONEY, Connecticut
BOB BARR, Georgia DARLENE HOOLEY, Oregon
SUE W. KELLY, New York JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio MAX SANDLIN, Texas
CHRISTOPHER COX, California GREGORY W. MEEKS, New York
DAVE WELDON, Florida BARBARA LEE, California
JIM RYUN, Kansas FRANK MASCARA, Pennsylvania
BOB RILEY, Alabama JAY INSLEE, Washington
STEVEN C. LaTOURETTE, Ohio JANICE D. SCHAKOWSKY, Illinois
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, North Carolina CHARLES A. GONZALEZ, Texas
DOUG OSE, California STEPHANIE TUBBS JONES, Ohio
JUDY BIGGERT, Illinois MICHAEL E. CAPUANO, Massachusetts
MARK GREEN, Wisconsin HAROLD E. FORD Jr., Tennessee
PATRICK J. TOOMEY, Pennsylvania RUBEN HINOJOSA, Texas
CHRISTOPHER SHAYS, Connecticut KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona RONNIE SHOWS, Mississippi
VITO FOSSELLA, New York JOSEPH CROWLEY, New York
GARY G. MILLER, California WILLIAM LACY CLAY, Missouri
ERIC CANTOR, Virginia STEVE ISRAEL, New York
FELIX J. GRUCCI, Jr., New York MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania
SHELLEY MOORE CAPITO, West Virginia BERNARD SANDERS, Vermont
MIKE FERGUSON, New Jersey
MIKE ROGERS, Michigan
PATRICK J. TIBERI, Ohio
Terry Haines, Chief Counsel and Staff Director
------
Subcommittee on Oversight and Investigations
SUE W. KELLY, New York, Chair
RON PAUL, Ohio, Vice Chairman LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York KEN BENTSEN, Texas
ROBERT W. NEY, Texas JAY INSLEE, Washington
CHRISTOPHER COX, California JANICE D. SCHAKOWSKY, Illinois
DAVE WELDON, Florida DENNIS MOORE, Kansas
WALTER B. JONES, North Carolina MICHAEL CAPUANO, Massachusetts
JOHN B. SHADEGG, Arizona RONNIE SHOWS, Mississippi
VITO FOSSELLA, New York JOSEPH CROWLEY, New York
ERIC CANTOR, Virginia WILLIAM LACY CLAY, Missouri
PATRICK J. TIBERI, Ohio
C O N T E N T S
----------
Page
Hearing held on:
May 23, 2002................................................. 1
Appendix:
May 23, 2002................................................. 63
WITNESSES
Thursday, May 23, 2002
Doherty, David, Executive Vice President for Enforcement, New
York Stock Exchange............................................ 12
Fazio, Carl, Defrauded Investor, Aurora, Ohio.................... 8
Hommel, Thomas, Managing Director and Co-Head of Global
Litigation, Lehman Brothers.................................... 37
Kaplan, Mark E., Managing Director and General Counsel, SG Cowen
Securities..................................................... 35
Lackritz, Marc E., President, Securities Industry Association.... 43
Richards, Lori, Director, Office of Compliance, Inspections, and
Examinations, Securities and Exchange Commission............... 11
Sibears, Daniel M., Senior Vice President and Deputy for Member
Regulation, National Association of Securities Dealers......... 39
Skolnik, Bradley W., Indiana Securities Commissioner and
Chairman, Enforcement Section, North American Securities
Administrators Association..................................... 41
Stout, Golda Lewis, Defrauded Investor, Elgin, Illinois.......... 10
APPENDIX
Prepared statements:
Kelly, Hon. Sue W............................................ 64
Oxley, Hon. Michael G........................................ 65
Jones, Hon. Stephanie Tubbs.................................. 67
LaTourette, Hon. Steve C..................................... 68
Doherty, David............................................... 79
Fazio, Carl.................................................. 126
Hommel, Thomas............................................... 104
Kaplan, Mark E.,............................................. 96
Lackritz, Marc E.,........................................... 122
Richards, Lori............................................... 69
Sibears, Daniel M.,.......................................... 109
Skolnik, Bradley W.,......................................... 116
Stout, Golda Lewis........................................... 129
Additional Material Submitted for the Record
Kelly, Hon. Sue W.:
Frank Gruttadauria letter to the Securities and Exchange
Commission and the Federal Bureau of Investigation......... 166
Jones, Hon. Stephanie Tubbs:
Arbitration Agreements between Richard Lopardo v. Frank
Gruttadauria............................................... 167
Duvin, Cahn & Hutton letter regarding Mr. Samuel Glazer, May
21, 2002................................................... 154
Gruttadauria Lawsuits Threaten Lehman Profits, Cleveland
Plain Dealer, April 17, 2002............................... 152
NYSE Investigating Gruttadauria ex-aide, Cleveland Plain
Dealer, April 27, 2002..................................... 150
New York Stock Exchange Hearing Panel Decision, July 10, 1998 135
LaTourette, Hon. Steve C.:
Account of Carl Fazio........................................ 157
Account of Dominic A. Visconsi, Sr.,......................... 158
Hommel, Thomas:
Written response to questions from Hon. Stephanie Tubbs Jones 186
Kaplan, Mark E.:
Written response to questions from Hon. Stephanie Tubbs Jones 190
Richards, Lori:
SEC's Examination Report on Frank Guttadauria, November 1993. 133
Sarantakis, Georgia C., Defrauded Investor, prepared statement... 159
Yale, Judy Meyerhoff, Defrauded Investor, prepared statement..... 163
ONE BROKER GONE BAD:
PUNISHING THE CRIMINAL,
MAKING VICTIMS WHOLE
----------
Thursday, May 23, 2002
U.S. House of Representatives
Subcommittee on Oversight and Investigations
Committee on Financial Services
Washington, D.C.
The subcommittee met, pursuant to call, at 9:30 a.m., in
Room 2128 House Office Building, Hon. Sue W. Kelly [chairwoman
of the subcommittee] presiding.
Present: Representatives Kelly, Ney, Cantor, Tiberi,
Inslee, Jones of Ohio, Clay, and Oxley (ex officio).
Also Present: Representatives Hastert and LaTourette.
Chairman Kelly. Good morning, ladies and gentlemen. This
hearing of the Oversight and Investigations Subcommittee of the
House Committee on Financial Services will come to order.
I want to thank all members of Congress who are present
today. Without objection, all members present will participate
fully in the hearing, and their opening statements and their
questions will be made part of the official hearing record.
On January 11, 2002, Frank Gruttadauria, a Cleveland branch
manager and broker, mailed a letter to the FBI admitting to 15
years of wilful fraud and theft of his clients' savings, and he
disappeared. In the aftermath of this revelation, law
enforcement, the regulators, the successive owners of that
branch, and Gruttadauria's clients, began to uncover the extent
of this one broker's deceitfulness and the intricate web of
lies that he employed to perpetrate his fraud.
We do know that Mr. Gruttadauria is accused of at least--
stealing at least $40 million of his client's savings, while
sending his clients fake statements stating that their savings
had grown to an estimated combined total of $260 million.
Today, Mr. Gruttadauria is in federal custody after less than a
month of being on the run.
It appears that his efforts to evade detection by the firms
and regulators were much better than his ability to evade the
law. One issue is clear: Mr. Gruttadauria and any who assisted
him will be punished for their crimes. From my initial review
of this case, Mr. Gruttadauria had the ability to perpetrate
this fraud because of his position in the Cleveland branch as
both manager and a broker. This put him in the position of
supervising himself, which is a key point in this case.
Another key point is the lack of complaints in regard to
Mr. Gruttadauria's actions. The majority of investigations
against problem brokers appear to be triggered by five or more
complaints. Since Mr. Gruttadauria was able to send false
statements to his clients and forged any authorization he
needed, he appears to have avoided scrutiny, including anything
that occurred through traditional warning signs.
The purpose of this hearing is to examine this case in an
effort to determine what steps are warranted to ensure that
similar fraud and theft is prevented. Our responsibility is to
ensure that scams such as this will not go undetected again. In
order to do this, we must take a step back from the particulars
of this case and examine the systems that firms and regulators
have in place to detect such fraud by managers' brokers.
We know that the securities industry is very full of
intelligent people. If they put their mind to it, they could
potentially inflict a great deal of harm on the savings of many
families and investors. To preserve and bolster investor
confidence, we must gain an understanding of how the current
systems were defeated so consistently over the course of
approximately 15 years by Mr. Gruttadauria.
I want to thank all of our distinguished witnesses for
taking the time out of their busy schedules to join us here
today. The committee understands the constraints that some of
our witnesses are under and their inability to discuss some of
the specifics of the case due to the ongoing nature of the
Gruttadauria investigation. The last thing we want to do is to
inadvertently harm the prosecution of Mr. Gruttadauria or any
of his accomplices.
We appreciate your willingness to come here today to
discuss the issues to the best of your ability. I also want to
make it clear to the members of this committee, and to our
witnesses, it is my intention to enforce the five-minute rule,
which limits statements and questions to a five-minute period.
This will ensure that everyone has an equal chance to state
their views, and I thank you all in advance for this effort.
I want to now recognize the Speaker of the U.S. House of
Representatives, our Speaker, Mr. Dennis Hastert, for an
introduction.
Mr. Hastert, we welcome you here today. Your presence lends
a great deal to this hearing. Thank you. Mr. Speaker, your mike
needs to be turned on.
[The prepared statement of Hon. Sue Kelly can be found on
page 64 in the appendix.]
The. Speaker. I haven't done this for a while. No.
[Laughter.]
Chairman Kelly, thank you very much for holding this
hearing today. I also want to thank Mr. LaTourette, because he
worked to bring this about, and also the Chairman of the full
committee for making this happen.
You know, one of our bases of wealth in this country is the
people having confidence in securities and 401Ks and money
markets and mutual funds that they can invest their money, the
money that they worked hard or inherited or saved or scrimped,
or however they accumulated it, and to see that money grow, so
that they can have something to live their life with and to
pass on to their children and their grandchildren. And we have
seen that wealth grow in this country over the last few years.
But I have a constituent here today, Mrs. Golda Stout, from
Elgin, Illinois, who invested over $600,000, or her life
savings, everything she had, with a broker, the same broker
that you had mentioned in your opening statement. She lost that
money, not because of fault of her own, in good faith, under
the confidence that she was investing with a brokerage house
that had a good name, a good reputation, and all of a sudden
that fortune, that savings, that lifetime investment that she
had, was gone.
We need to make sure that, first of all, those people who
perpetrated those deeds are punished. But that certainly
doesn't make whole those people who were the investors. We also
need in this Congress, the body that makes the laws for this
country, to make sure that we have a system in place that
people have confidence that they can invest in the markets,
invest in the security systems that we have today, that they
have confidence that if a brokerage house is there and has a
good name, it is something that they can have confidence in,
and that there is a system, that we have checks and balances,
that this type of thing doesn't happen again.
So, Madam Chairman, thank you for having this hearing
today. Again, I want to thank Mr. LaTourette for bringing this
forward, and for the Chairman of the full committee for
allowing this hearing. But most important, I also want to thank
those people who are here today to bring this issue forward, to
lay out what the problem is, and try to help us to start to
find the solutions to this problem.
I also, again, want to thank my constituent, Mrs. Golda
Stout, for being here today and testifying.
So thank you very much, Madam Chairman.
Chairman Kelly. Thank you very much, Mr. Speaker.
We go now to the Chairman of the full committee, Mr. Oxley,
for an opening statement.
Mr. Oxley.
Mr. Oxley. Thank you, Madam Chairwoman.
And, Mr. Speaker, thank you for your appearance before the
committee today. We welcome you back anytime.
I want to take this opportunity to thank you, Mrs. Kelly,
for this important hearing. The subject of today's hearing, Mr.
Gruttadauria, who had as many as 470 clients during the height
of his success, earning more than $6 million in commissions in
a good year, for some unknown reason that was apparently not
enough. It appears that over 15 years he sent false statements
to two dozen or more of his clients.
It is further alleged that over the same 15-year period he
misappropriated possibly hundreds of millions of dollars,
somewhere between $125- and $700 million from those clients,
several of whom treated him as warmly as they would members of
their own families. One client even made him the executor of
his estate.
He was never caught. Apparently, feeling that he was on the
verge of being found out, he called his activities to the
attention of the FBI, fleeing to Colorado where he eventually
surrendered to authorities. State and federal authorities, as
well as the brokerage firms which employed him, are continuing
their months-long effort to uncover the extent of his
activities. We can only hope that those efforts will bring a
sense of closure to his many victims and their families.
It is my sincere hope that our efforts today will be of
help in this ongoing investigation. We will have the
opportunity to hear directly from several of Mr. Gruttadauria's
victims, and we will learn first hand from them how he
concocted a scheme whereby he misdirected their brokerage
account statements to post office boxes which he rented and
personally controlled. He then created false statements in
order to mislead his clients about the real value of their
investments.
Although some may feel that outages of the sort that were
inflicted by Mr. Gruttadauria upon his trusting clients are
systemic, the efforts being undertaken by the law enforcement
prosecutors, SEC, and New York Stock Exchange, Lehman Brothers,
and S.G. Cowen Securities would certainly indicate that this is
certainly not the case. Hindsight is always perfect, yet our
examination revealed that there were missed opportunities for
the various authorities to stop his criminal activity.
The presence of representatives today from the SEC, New
York Stock Exchange, the SIA, National Association of
Securities Dealers, and North American Securities
Administrators, underscores their commitment to ensure that
violations of securities law such as this particularly
egregious case do not occur in the future, and I look forward
to hearing from them today about their efforts.
Let me also note that this committee was pleased to work
with the SEC in order to provide it with a significant increase
in its budget to allow for a much needed escalation of its
enforcement capabilities. As a matter of fact, we provided in
the reauthorization bill that passed this committee unanimously
a 50 percent increase in the budget in the Enforcement Division
of the SEC.
Apparently, the SEC also had some information years ago on
Mr. Gruttadauria, and I also look forward to hearing from the
SEC about how it will improve its processes.
Before I close, Madam Chairwoman, I want to particularly
pay tribute to our good friend, Steve LaTourette, for his
doggedness and his determination on this case. Steve was a
renowned prosecutor before he came to Congress, and he has
taken those skills with him on this committee. We are pleased
to have him on the committee as a very aggressive and active
member, and this hearing, in many ways, is a tribute to his
steadfastness on this issue.
And I am pleased to yield back the balance of my time.
[The prepared statement of Hon. Michael G. Oxley can be
found on page 65 in the appendix.]
Chairman Kelly. Thank you very much, Mr. Chairman.
We now go to Ms. Tubbs Jones.
Mrs. Jones of Ohio. Thank you, Madam Chairwoman.
To our Chairman of the committee and my colleagues, I find
myself this morning in a sad situation. I look out in the
audience, and I see people from the 11th Congressional
District, who I have known for many, many years, in a position
where their life savings have been denigrated as a result of
the conduct of Frank Gruttadauria.
When I look out in the audience, I see former Council
President Jim Stanton from the great city of Cleveland; Mary
Boyle, a County Commissioner from Cuyahoga County; Mr. Carl
Fazio--and we have a great relationship because his grandson
Anthony and my son Mervin attended school together.
It is, in my opinion, a shame that we would be here this
morning where we have someone who has literally deprived
hardworking people, who have worked all of their lives, of
their life savings, of that blanket to cover them in a time of
most need.
As we come today before this subcommittee, there are
several questions that we will all want to have answered, but
particularly of interest to me will be what, in fact, the SEC,
in 1993, knew about Frank Gruttadauria and did not do enough to
keep him from being engaged in a conduct subsequently.
I do want to have admitted to the record at some point,
Madam Chairwoman, a finding by the New York Stock Exchange from
1998 of conduct of Frank Gruttadauria and S.G. Cowen's failure
to supervise producing branch manage officers acting in the
capacity of registered representatives. In this instance, we
have Frank Gruttadauria acting as a branch manager/officer,
who--and the compliance officer within that company was the
person who reported directly to Frank Gruttadauria. If that is
not a signal that something is going wrong, I don't know what
is.
[The following information was subsequently furnished by
Hon. Stephanie Tubbs Jones for the hearing record.]
Chairman Kelly. Without objection.
Mrs. Jones of Ohio. Thank you.
It is our job as members of Congress to sit and listen
intently, constantly try to keep our sympathies for the victims
of these crimes from clouding our objectivity that we must
maintain. However, it is a tough piece to try and keep that
sympathy from clouding part of our judgment in this instance.
But be that as it may, Frank Gruttadauria, who--frankly,
whose conduct is shocking--is alleged to have stolen tens of
millions of dollars, and I won't repeat that because everyone
said that. But for the record, everyone knows the amount of
dollars and the people involved. But how was he able to gain
the trust of so many people? How was he able, for 15 years, to
engage in this conduct and go undetected? How is it that there
were prior violations by--noted by the New York Stock Exchange
and the SEC where he was able to continue in his conduct?
And by the end of this hearing this morning, it is my hope
that we will have information sufficient to assist these
victims in the process of attempting to collect their dollars
back from either Frank Gruttadauria or his supervisors, or the
investment companies that are involved.
But even more so, that we will have information and
opportunity to see that we put in place rules and regulations
that will not allow other people to be victimized as a result
of such conduct, and that we will be able to look past and
maybe even foreshadow some of the other conduct that investors
are engaged in in this instance.
I yield the balance of my time, Madam Chairwoman. I want to
compliment you and my colleague from northeast Ohio, Steve
LaTourette, for giving us the opportunity to have this hearing
this morning.
Thank you very much.
[The prepared statement of Hon. Stephanie Tubbs Jones can
be found on page 67 in the appendix.]
Chairman Kelly. Thank you very much, Mrs. Tubbs Jones.
We turn now to Mr. Tiberi.
Mr. Tiberi, do you have an opening statement?
Mr. Tiberi. I do not have an opening statement, Madam
Chairwoman.
Chairman Kelly. Thank you.
We turn to Mr. LaTourette. Mr. LaTourette, we are pleased
to have you join us this morning.
Mr. LaTourette. Thank you very much, Madam Chairwoman, and
I want to thank you, and also the Chairman of the full
committee, Mr. Oxley, for convening this hearing today.
I also want to compliment your staff, Madam Chairwoman, for
the outstanding investigatory work that they have done in
getting us ready for this hearing. And there is a number of
people we could talk about, but Andy Cochran, who is seated to
your left, has really done an outstanding job, and he deserves
our thanks for getting us to where we are today.
Madam Chairwoman, many of us in the greater Cleveland area
were startled, shocked, and dazed when we found out that a
number of our friends and neighbors had been victimized by a
broker who worked for Lehman Brothers, Frank Gruttadauria. We
discovered that he had fled town, leaving a note and a computer
disk for the FBI, after bilking the firm's clients out of money
that has ranged from $40 million, it has been complained of,
to, as the Chairman of the full committee indicates, up to $700
million.
I know we have Mr. Fazio here today, who will talk about
$26 million that he and he alone lost. His victims ranged from
some very wealthy people to moderate income people, who were
investing for their retirement years.
By maintaining a desktop computer, in violation of his
firm's rules, by setting up a phony post office box, by mailing
fraudulent statements and juggling funds, it appears that Mr.
Gruttadauria was able to craft a Ponzi scheme that lasted for
15 years, and only collapsed, despite what I read in The Wall
Street Journal today, only collapsed because there was a cash
call on a divorce case of a rather wealthy client, and also
because of the persistence of Mrs. Golda Stout. And I think
that perhaps the SEC and some of the regulators should hire
Mrs. Stout to supervise and watch things. It is my
understanding that she initially indicated she wanted to view
her investments online, was told that, ``Oh, we don't offer
that service,'' and it is only because she kept pushing and
pushing and pushing that eventually Mr. Gruttadauria, among
other reasons, left town.
Some will come before this subcommittee today and say that
this is just one very crooked broker gone bad, we are really
sorry, but it happens, but that there are no systemic
difficulties or problems that require the attention of this
committee or any other committee in the Congress. That might be
the case were there not some historical context not only for
the Book of Business while it was maintained by S.G. Cowen, but
also after it was purchased by Lehman Brothers.
Mrs. Tubbs Jones and others have mentioned the 1993
complaint, and in that complaint the SEC discovered that Mr.
Gruttadauria was in charge of an account that had an equity of
$96,000. It had losses of $86- to $88,000, and commissions
charged of $39,000 in a six-month period. It is my
understanding--and we are looking forward to hearing from the
SEC today--but they neglected to talk to the account holder and
only talked to Mr. Gruttadauria.
Someone who will not show up today as a witness is a friend
of mine from Cleveland, Dominic Visconsi, Sr. His accounts will
enter into evidence later, returned over a four-year period 54
percent, 99 percent, 19 percent, 100 percent, and 43 percent.
Also, Ms. Tubbs Jones mentioned the fine levied by the New
York Stock Exchange for failure to supervise in 1998. And at
the same time, Madam Chairwoman, Lehman Brothers was involved
in litigation by another broker by the name of Ahmed Dahouk,
who maintained a desktop computer, set up phony post office
boxes, mailed fraudulent statements, juggled funds, and
apparently in doing the due diligence when they purchased the
Cowen business this did not seem to raise any red flags.
Lastly, Madam Chair, it is my understanding that the
supervising partner at Lehman Brothers, who supervised Mr.
Gruttadauria for the year that he had the business, earned a
base salary of $450,000, received bonuses of $8 million, and
stock options of $29 million. And the question that I think
needs to be raised is: why should he be worried about what
happened with Mr. Gruttadauria and his clients?
Thank you. I yield back.
[The following information was subsequently furnished by
Hon. Steve C. LaTourette for the hearing record.]
Chairman Kelly. Thank you, Mr. LaTourette. And without
objection, we will accept that in the record.
Also, without objection, I would like to enter into the
record a copy of the letter that Mr. Gruttadauria sent to the
Cowen & Company and to Chase Manhattan and to the FBI. He sent
copies of it to a number of people, not just those two listed.
And without objection, that letter will also be included in the
record.
With that, if there are no further opening statements, I am
going to introduce the first panel. We sincerely appreciate the
effort it took for all of you to prepare your testimony, and
the two of you who have traveled here some distance to be here
today with us.
Our panel includes Mr. Carl Fazio of Aurora, Ohio; and Mrs.
Golda Lewis Stout of Elgin, Illinois; both of whose finances
were devastated by Mr. Gruttadauria's fraud. Lori Richards, the
Director of Office of Compliance, Inspections, and Examinations
at the Securities and Exchange Commission. We welcome you, Ms.
Richards. And Mr. David Doherty, Executive Vice President for
Enforcement at the New York Stock Exchange.
I want to thank each of you for agreeing to testify before
us today, and I welcome you on behalf of the committee.
Without objection, your written statements and any
attachments will be made a part of the record. You will each
now be recognized for a five-minute summary of your testimony.
There are lights in front of you that will indicate how much
time you have. You see the boxes there on the table.
The green light signifies that you are in the first four
minutes of your summary. The yellow light will turn on when you
have a minute remaining. And the red light will turn on when
your time has expired.
And we will begin now with you, Mr. Fazio. Thank you for
being here.
STATEMENT OF CARL FAZIO, AURORA, OHIO
Mr. Fazio. Thank you, Chairman Kelly, Members of the House
Financial Services and Oversight and Investigations
Subcommittee. Thank you for inviting me to be with you today. I
will share with you my family's story of betrayal by four of
America's great institutions--Lehman Brothers, Cowen & Company,
S.G. Cowen, and Hambrecht & Quist.
Caution shown by today's investors not only reflects the
lack of confidence the public has in corporate accounting; it
demonstrates that the public also understands that major
investment banking firms only say the right thing. They do not
do it, and, more importantly, they apparently turn a blind eye
when investors are hurt.
I am Carl Fazio. I came to this country at the age of
three. Through great effort and energy, my family was able to
build one fruit stand into Fisher-Fazio's, a major chain of
supermarkets which ultimately became a New York Stock Exchange
company. At the time of its sale, I was its chairman, and we
employed approximately 20,000 people.
Today, as I stand before you, although I earned and
invested a handsome amount of money, I have a few liquid
assets. I am unable, at the age of 85, to pay my bills as they
become due, and I am forced to sell my home, all because of the
greed of Lehman Brothers, Cowen & Company, S.G. Cowen, and,
possibly, Hambrecht & Quist.
While focusing on generating fees, they failed to police
their own brokers and employees. We have only recently learned
that the New York Stock Exchange, in a disciplinary proceeding
against Cowen & Company dealing with 1994 and 1995, criticized
it for having compliance people subordinate to branch office
managers. Even though the Stock Exchange found this deficiency,
it was never corrected.
In Cleveland, Robert Semanek, the firm's compliance person,
reported to Frank Gruttadauria. This is wrong. Neither Cowen &
Company, S.G. Cowen, nor Lehman Brothers changed their
procedures. That is a key reason why Frank Gruttadauria could
generate fraudulent statements on his personal computer which
he had in his office.
He had the computer even though, according to some
newspaper reports, it was against company policy. My assets
have been stolen from me, not just by Frank Gruttadauria, but
by the collective efforts of the brokerage firms that lent them
their credibility and resources and turned their backs on
protecting me.
After the sale of my company, at the request of my first
wife, through her close friend, I entrusted some of my funds to
Frank Gruttadauria and his firm. Over the years, he became as
close to me as one of my own sons. I viewed him as a member of
my family and proudly watched him receive accolades in the
investment community and rise up the ladder to becoming a
senior director of S.G. Cowen and the branch office manager for
Lehman Brothers.
His positions in the companies gave me confidence. Little
did I know that at some time, from the little records that I
have been able to get since Frank Gruttadauria admitted his
frauds and ran away, maybe as early as the 1990s, he took my
money and misappropriated it in order to grow his commission
income, all the while sending me false statements which
reflected the trades I sought in the market.
He did this while encouraging me to deposit more and more
money. Ultimately, all of my liquid assets were put under the
control of Frank Gruttadauria, who stole them.
I believe I am a very knowledgeable investor. I told Mr.
Gruttadauria what I wanted to buy and what I wanted to sell. I
made my own trades. I was in constant contact with him and his
office, and I reviewed what I believed to be confirmations and
my statements. Little did I know that I was dealing with smoke
and mirrors.
Now their greed has devastated me. And if the brokerage
firm's actions are not bad enough, S.G. Cowen, a brokerage firm
I sued, is now attempting to manipulate the court system by
removing my claim to arbitration. As they said in their motion,
and I quote, ``Plaintiffs must pursue their claims in
arbitration before a panel of--an appropriate self-regulatory
organization.''
I am 85 years old. I need this money to live on now. On
January 28, I met with Lehman Brothers and told them of my
urgent need for money.
And I would like to close by reading you a portion of
Lehman's mission statement. I quote, ``We are one firm, defined
by our unwavering commitment to our clients.'' In my situation,
they not only wavered, they punted, and now they just don't
care.
Thank you for your time.
[The prepared statement of Mr. Carl Fazio can be found on
page 126 in the appendix.]
Chairman Kelly. Mr. Fazio, we thank you for your statement.
That is certainly a very, very moving statement.
I want to explain to the people here, and to our panel,
that the business on the floor today is such that we may be
moving back and forth to vote. We have a vote that has just
been called.
So what I am going to try to do in order--because I know
some of you have planes that you need to meet, and so forth, I
am going to be trading off the Chair with people, so that we
are going to have a rotating group of people moving back and
forth, so that we can keep this hearing open and keep it going.
So with that being said, I hope you will indulge us in
changing people sitting in this char. I am still running the
hearing, and I will be back. I am going to be going back and
forth to vote now and then.
With that, I want to go to you, Mrs. Stout.
STATEMENT OF GOLDA LEWIS STOUT, ELGIN, ILLINOIS
Mrs. Stout. I, too, want to thank the members of the
Financial Service Committee and the subcommittee for inviting
me to testify. Over the past months, I have watched others
testify. I am impressed with their apparent confidence and calm
demeanor. I assure you that this is not my state at this
moment.
As my opening statement, I want to share with you an edited
version of a letter sent to my Congressman for my district,
Dennis Hastert. I met Dennis Hastert in Elgin many, many years
ago when he was campaigning for his first term of the House of
Representatives. We were both much younger at that time.
I was born in 1915 on a small farm in central Iowa. I
suffered, along with millions of other American citizens, the
ravages of depression. I made a commitment to work hard and
save. My life has been productive, and I am very proud of my
accomplishments. I have a family which I truly love, and they
have the same feeling for me.
As a result of my savings and investing, I felt secure in
knowing that my remaining years of life would be without
financial worry, but all that was changed in January of 2002
with the news of the fraud perpetrated on many others and on me
by the managing director of the Cleveland office of Lehman
Brothers, Frank Dominic Gruttadauria, who formerly worked for
S.G. Cowen, Cowen & Company.
The complete story of Mr. Gruttadauria will not be known,
if ever, for years to come. However, by his own witness
statements to the FBI, he has defrauded his clients for over 15
years. Given some of the most recent articles, it appears to me
that the process of recovering my lost investments may be long
and expensive.
While I trusted my broker as many investment companies are
stressing in their television advertising, I was not passive
with the respect to monitoring the stockmarket and investment
portfolio. I tracked the markets daily and have records going
back to 1992. And I also verified my portfolio balance with
each monthly report.
However, I did not receive the true reports. They were sent
elsewhere by the brokerage firm as a result of Mr.
Gruttadauria's actions. Instead, I received a very authentic-
looking account statement, which agreed with my own personal
records. I also received yearly the 1099s, which my accountant
used to prepare for the individual tax returns. And over the
years, Mr. Gruttadauria was privately looting my account. All
of this occurred without detection by myself.
This brings me to the main point. Stockbrokers' misdeeds
must be prevented from occurring again to any person who uses a
brokerage account as an investment vehicle. As we all know,
Social Security should not be the foundation of any retirement
plan. IRAs, 401Ks, and other investment activities are the real
foundation for retirement. In almost all cases, these
activities will involve investments using a brokerage firm.
As pointed out in the article in The Wall Street Journal,
the Plain Dealer of Cleveland, active compliance monitoring and
reporting is critical. My hope is that you and your colleagues
in the Congress can address, to the greatest extent possible,
the need to prevent stockbroker fraud and to require the
brokerage firms to monitor and enforce compliance by their
officers and employees.
Thank you.
[The prepared statement of Ms. Golda Lewis Stout can be
found on page 129 in the appendix.]
Chairman Kelly. We thank you, Mrs. Stout.
We will go next to you, Ms. Richards.
STATEMENT OF LORI RICHARDS, DIRECTOR, OFFICE OF COMPLIANCE,
INSPECTIONS, AND EXAMINATIONS, SECURITIES AND EXCHANGE
COMMISSON
Ms. Richards. Chairwoman Kelly, Chairman Oxley, members of
the subcommittee, I appreciate the opportunity to appear before
the subcommittee today on behalf of the Securities and Exchange
Commission to discuss the Frank Gruttadauria matter and
potential measures to prevent theft by registered
representatives of stockbrokers.
As I think you know, the SEC filed an enforcement action
against Mr. Gruttadauria alleging that he misappropriated
customer funds for his own purposes, directing those funds to
other customers' accounts, either as purported returns or to
satisfy their withdrawal requests. In essence, this was a Ponzi
scheme, pure and simple, taking money from some clients to
cover the withdrawal requests that were made by other clients.
The SEC alleges that Mr. Gruttadauria forged client
signatures on withdrawals, made unauthorized transfers of
funds, and took customer funds purportedly to open accounts,
but never actually opened accounts. Then, to conceal the fraud
from his customers, he created and sent false account
statements to customers that greatly overstated the values of
their accounts, and caused the clients' actual account
statements to be sent to post office boxes under his own
control.
I want to say, listening to the victims, Mrs. Stout and Mr.
Fazio, how much I empathize with them.
I know that the subcommittee is most interested in what can
be done to prevent future conduct like Mr. Gruttadauria's. At
the most basic level, firms are responsible for establishing
systems of supervision and internal controls that are
reasonably designed to ensure that their employees are in
compliance with the law. Broker-dealers are required, under
current law, to have adequate procedures and controls to
identify the kind of sales practices that Mr. Gruttadauria
engaged in, and to conduct regular reviews of their employees'
activities.
I am pleased to tell you that many firms have in place
procedures to help them prevent and detect fraud by brokers. My
written testimony that I submitted sets out, in some detail,
some of the procedures that firms can use, including things
like verifying changes of address directly with the customer,
confirming customer authorizations to transfer funds out of
their account, paying special attention to post office boxes
and other addresses that are not the customer's home address,
exercising control over account statements, supervising
employees' use of personal electronic devices, and providing
independent supervision and review of activity by producing
managers. These are, I think, very important.
I would like to switch gears for just a minute and briefly
address the SEC's examination efforts. In one of our
examinations in 1993, as has been raised today, we came very
close to Mr. Gruttadauria. We conducted a cause examination of
the Chicago, Illinois, office of Cowen where Mr. Gruttadauria
serviced some of his accounts, after receiving an anonymous tip
that alleged churning (or excessive trading) in one of his
accounts.
While there were some flags that prompted the SEC examiner
to conduct a detailed review of that particular account and
other Gruttadauria accounts in the Chicago office, the
examination was unable to establish sales practice abuse in
that account sufficient to warrant further action. Now, I will
say that knowing what we know now, I wish I could say that we
had detected the fraud in 1993.
Well, what has the SEC done in response to this event? As
you would expect, we have worked closely with the New York
Stock Exchange and the NASDR to understand the alleged fraud in
this case, and we intend to continue to vigorously prosecute
Mr. Gruttadauria. Together with the SROs, we are focusing
particular attention on examining firm procedures and systems
to prevent fraud of this type in the future.
We have reminded securities firms of the importance of
these procedures, and we will also be conducting a series of
examinations focused solely on firm procedures designed to
prevent theft by registered representatives.
We intend to ensure that the best practices that I have
described in my testimony become the universal practices in the
securities industry.
I am pleased to answer any questions that the subcommittee
may have.
[The prepared statement of Ms. Lori Richards can be found
on page 69 in the appendix.]
Mr. LaTourette. [presiding] Thank you very much, Ms.
Richards.
And before I yield to Mr. Doherty, for those of you from
Cleveland or Illinois that don't come here on a regular basis,
there is a 15-minute vote on the floor, and so I ran as quickly
as I could to get to the Capitol and come back so we can keep
the testimony going. And our colleagues will come back and join
us for the question and answer period.
So I apologize that we are conducting legislative business
at the same time we are doing this, but we wanted to not
inconvenience anybody.
Mr. Doherty, welcome, and we are looking forward to hearing
your testimony.
STATEMENT OF DAVID DOHERTY, EXECUTIVE VICE PRESIDENT FOR
ENFORCEMENT, NEW YORK STOCK EXCHANGE
Mr. Doherty. Thank you. Good morning, Chairwoman Kelly, and
members of the committee. I appreciate the opportunity to talk
with you this morning about how the New York Stock Exchange
regulates our member firms, and to provide some information
about actions we have taken concerning Cleveland broker Frank
Gruttadauria and others associated with him.
Regulation of the securities industry in the United States
depends upon self-regulation and begins with the broker-dealer
itself. The Exchange plays a critical role by maintaining an
extensive system for monitoring and regulating the activities
of its membership with SEC oversight. The regulatory group of
the Exchange currently employs approximately 560 people
representing over one-third of the entire Exchange's staff,
with an operating budget of $142 million.
The Division of Member Firm Regulation, with a staff of
265, oversees 260 member organizations that employee nearly
160,000 registered persons and service nearly 93 million
customer accounts. That is more than 85 percent of the public
customer accounts carried by broker-dealers in the United
States.
Our staff conducts annual on-site examinations of every one
of these firms. We visit the main office and approximately 200
branch offices each year, which are selected using a risk-based
analysis. Our criteria and methodology for selecting branch
offices for review is constantly being upgraded and refined
based on experience and new technology. A more complete
description of our exam program is included in my written
testimony.
Serious or repeated violations found by our examiners are
referred to the Exchange's Enforcement Division. The
Enforcement Division, which has a staff of about 136, carries
an inventory of approximately 700 cases and initiates over 200
enforcement actions a year. Enforcement staff conduct
investigations often in cooperation with the SEC and decide
whether to institute formal enforcement proceedings. Possible
sanctions or penalties include censures, fines, suspensions, or
permanent bars from our membership.
The short-term objective of an effective enforcement
program is to catch and punish the people who break the rules.
The long-term objective is to deter other violative activity,
induce compliance, and ultimately enhance investor confidence
in the integrity of the market.
I would like to address the matter involving Mr. Frank
Gruttadauria, the former broker for Lehman Brothers and S.G.
Cowen. The Exchange learned of the Gruttadauria matter on
January 22 of this year when we were contacted by officials
from Lehman Brothers. We responded immediately by putting
together a team of enforcement attorneys and examiners, meeting
with the compliance officials at Lehman, discussing the case
with the SEC, and beginning an investigation.
That investigation, which is ongoing, focuses on the manner
in which Gruttadauria conducted his activities, the supervisory
structure and procedures in the Cleveland office, and the
overall supervisory structure of both Lehman and S.G. Cowen.
The Exchange is working cooperatively with the SEC's
Enforcement Division in this investigation.
The Exchange has taken the following actions so far
regarding the Gruttadauria matter. On February 5, two weeks
after first being notified of this matter, we issued charges
against Gruttadauria for misappropriation of customer funds and
failure to cooperate with Exchange investigation. A hearing was
held, findings were made that he was guilty as charged, and on
March 19 he was censured and permanently barred from
association with any New York Stock Exchange member firm.
Also, in February and April, we issued charges against two
of Gruttadauria's assistants based on their refusal to provide
required information to us. It is worth noting that in 1998 the
Exchange brought formal enforcement proceedings against Cowen
for a number of violations. A major focus of the case was
improper order ticket procedures, failure to comply with margin
requirements, but other violations included failure to
reasonably supervise producing branch office managers and
failure to comply with rules governing discretionary accounts,
among others.
This resulted in a decision by consent in which Cowen
received a censure, a fine of $380,000, and a requirement was
imposed that Cowen correct procedural and supervisory
deficiencies. Cowen's compliance with the 1998 decision is one
of the matters that is under review in our current
investigation.
Since the beginning of this year, the Exchange has
undertaken a number of initiatives focusing on compliance
systems and procedures at retail firms. These initiatives were
partly in response to the Gruttadauria matter, but they also
reflect our commitment to continually review, expand, and
improve our regulatory program to adapt to new information and
technological advances.
So, we have already permanently barred Frank Gruttadauria.
We are investigating the supervisory structures at the firms
where he worked. We have enhanced our examination procedure,
and we have under consideration adoption of new rules to
strengthen investor protection in this area.
Let me assure you of the Exchange's continuing commitment
to our strong regulatory program. Thank you again for the
opportunity to testify today.
[The prepared statement of Mr. David Doherty can be found
on page 79 in the appendix.]
Mr. LaTourette. Mr. Doherty, we thank you very much for
your testimony.
The schedule indicates that other members of the panel,
including the Chairman, will be back shortly. And so in light
of the fact that there is great interest in asking questions of
everyone who has testified so far, I think it is the Chair's
predisposition to take a short recess. If you could not wander
too far, so that when Mrs. Kelly comes back we don't have to
gather people from the far reaches of the building, I would
appreciate that.
And the subcommittee will stand in recess, subject to the
call of the Chair.
[Recess.]
Chairman Kelly. [presiding] Is Mr. Doherty in the room?
Absent Mr. Doherty, I think we will go ahead with some--with
the questions. I would like to ask some questions of you, Ms.
Richards.
Ms. Richards, on page 5 of your testimony, you refer to
firm practices to prevent and detect fraud. One of these
policies is, and I quote, ``special attention to P.O. boxes.''
Now, we are aware that this was a key way in which Mr.
Gruttadauria was able to perpetuate his scam. Is this policy a
requirement of the SEC or just a suggestion?
Ms. Richards. I guess I think that under a broker-dealer's
existing duty to supervise, they have an obligation under
existing rules and regulations to make sure that their
supervision is adequate. And use of P.O. boxes has been found
not only in this case, but also in other cases, to facilitate
fraud by registered representatives. This is not the first time
that this P.O. box trick has been used.
So in light of that, I think that broker-dealers must,
under existing obligations to supervise, pay special attention
to the use of P.O. boxes. And there is nothing inherently wrong
with the customer using a P.O. box. Many customers in rural
areas, for example, use a post office box. But when a firm sees
that a customer has a post office box, they ought to pay
special attention to ensuring that the customer has truly
authorized the firm to use the P.O. box.
Chairman Kelly. Perhaps, Ms. Richards, it might be a good
idea if the SEC took another look at some kind of oversight on
the use of P.O. boxes. Would you agree?
Ms. Richards. Absolutely. And that is exactly what we are
doing now. Immediately after the Gruttadauria case broke, we
met with the New York Stock Exchange and the NASD and decided
to pay collectively, as securities regulators, special
attention on these what I think are very basic compliance
procedures designed to prevent theft.
So in all of our examinations going forward, we intend to
focus on firm procedures, not only in this area but in the
other areas that I have identified in my testimony. If through
that process we determine that additional rules or regulations
are appropriate, we intend to alert the Commission to that
early, and to work closely with the self-regulatory
organizations in determining whether or not additional
rulemaking is appropriate.
Chairman Kelly. So, once again, though, you are looking at
allowing the firms themselves to govern what is happening with
regard to the relationship of the post offices boxes with
regard to their clients and the delivery of the statements for
the accounts. Is that correct?
Ms. Richards. Firms have an existing duty to supervise, and
this is an area where they have got to pay, in my view,
enhanced attention--compliance attention--to. They have got to
scrutinize use of post office boxes carefully. I don't think it
would be appropriate for regulators to prohibit the use of post
office boxes, as I said, because many customers in rural areas
in particular need to use post office boxes.
But when the firm sees that a customer has a P.O. box, or
an``in care of'' address, or any address other than their home
address, they need to pay particular attention to that.
Chairman Kelly. Well, let us go to an exam that was
conducted by your examiner in 1993. You mentioned it on pages 4
and 5 of your testimony. That they did not contact the customer
that was involved. Is it a normal practice to contact the
customer when the account is being examined?
Ms. Richards. It is a judgment call that is made by the
examiner, based on the facts that are developed during the
examination. If I could, I would like to describe to you in a
little bit more detail what happened in the 1993 exam.
Chairman Kelly. Prior to your description, I would like to
simply say that I understand this was done in December of 1993,
that it was signed off by five supervisors, there is five
signatures on that. I also would like you to submit that for
the record within the next 24 hours. Will you please comply
with that request?
Ms. Richards. We have made the entire examination report
available.
Chairman Kelly. No, ma'am. I want it submitted for record.
Ms. Richards. I would have to go back to our Commission and
ask for authority to do that.
Chairman Kelly. Will you please do that?
Ms. Richards. Yes, I will.
Chairman Kelly. Proceed with what your explanation was.
[The following information was subsequently furnished by
Ms. Lori Richards for the hearing record.]
Ms. Richards. In 1993, the Commission received an anonymous
complaint about a customer's account that was maintained by Mr.
Gruttadauria. The anonymous complaint alleged that there was
churning in the account, and churning is simply excessive
trading, trading that is not appropriate for the particular
customer. It is designed to provide the registered
representative with commissions, but involves trading that is
not appropriate for the customer.
Based on that anonymous complaint, the Commission went in--
examiners in Chicago went in to Cowen's Chicago office and
conducted an examination focused primarily on that particular
account. They examined the account statements that were
provided not by Mr. Gruttadauria but by the firm itself, and
the examiner noted that the trading was very significant. There
was a lot of trading in the account during a six-month period
three years before the examination.
The fact that there was frequent trading, in and of itself,
while it is a red flag, it is not in and of itself violative,
because many customers engage in frequent trading. So what the
Commission then does, after it noted that there was such
frequent trading, in fact, the examiner computed a turnover
rate in the account of 18 times. That is very significant. That
is a lot of trading.
So with that information, the examiner then looked at
whether or not the trading was indicative of a violation of the
law. And the elements of a churning violation are really just
two. First, is the trading excessive for that particular
customer? And then, second, does the registered representative
have control over that particular account? So the turnover
ratio is just one part of the analysis.
The next step was to review the background of this
particular investor. The account documents that were provided
by the firm, not by Mr. Gruttadauria but by the firm, indicated
that this was an experienced investor. This was someone with a
very significant net worth of about $5 million and with 10
years or so of trading experience in equities and options.
Based on that, it appeared to the examiner that this was an
experienced trader, an experienced investor.
The next step was to review who was directing the trades,
because this is an element in a churning charge--the trades
must have been directed by the registered rep. Based on the
registrant and Mr. Gruttadauria, the examiner was told that the
trades were unsolicited. That is, that the investor herself was
directing the trades.
The Commission's examination procedures at that time would
require the examiner to confirm that statement by looking at
the order tickets.
The next step was to review other customers' accounts,
because what we often find is that when a registered rep is
engaged in churning one account, they will churn other
customers' accounts. So we looked at a sample of Mr.
Gruttadauria's other accounts in the Chicago office and found
no indications of churning. We also--
Chairman Kelly. May I--I am sorry to interrupt you, but the
account information that Mr. LaTourette has submitted for
record today indicates that there was at least one account, if
I am looking at it correctly, that was churned, in 1993, had a
turnover ratio of 34 percent. He made a 99 percent commission
rate on that.
In 1995, which was post this examination, there were some
other really egregious types of churning here that should
certainly but the ratio of 34 certainly ought to have had a red
flag in 1993. I am going to interrupt your testimony here, but
just because I have a question. I am going to run out of time,
and I need to talk to Mr. Doherty. I am going to go--I would
like to go back to you. I will go back to you. So stop yourself
where you are, and we will come back.
I want the rest of the--I would like you to read into the
record, or state for the record, exactly what happened in the
1993 exam. But I also want to caution you that the committee
would expect a response from your organization within the next
24 hours regarding that report.
Mr. Doherty, I wanted to ask you just one question, and I
will come back to you. On page 13 of your testimony, you
mention your 1998 enforcement action against Cowen for, among
other things, and I am quoting-- ``the failure to reasonably
supervise branch office managers acting in the capacity of
registered representatives.''
And then you also mention on page 14 of your testimony--
and, again, I am quoting--``in 1999, outside counsel concluded
in its report to the Exchange that Cowen had satisfied its
undertaking in all material respects and made significant
efforts in addressing areas of deficiency.''
I would like you to try to discuss what steps were taken to
improve the supervision of branch office managers at that
point, and any reasons that you are aware of that this improved
supervision didn't detect Mr. Gruttadauria's actions. These
people were defrauded. These people have lost their life
savings.
Mr. Doherty. They certainly have. The enforcement
proceeding that we brought in 1998 we considered to be a very
significant one. There were a number of violations involved. A
small part of it related to failure to supervise producing
branch office managers in the 1995 exam in one of the New York
offices.
We were sufficiently concerned with the supervisory
deficiencies in that case that we not only imposed a
significant fine, but we required, as a part of the settlement
that Cowen entered into that a consultant be appointed who
would come in and look at the systems and procedures that Cowen
was putting in place and make an evaluation as to whether those
systems and procedures, as enhanced, were adequate.
And the consultant--it was an outside law firm--did that
and filed a report and represented that they had confirmed that
a number of enhancements had been made, such as the firm had
appointed a senior person full-time whose job was to supervise
producing branch office managers.
There was an indication and confirmation that the firm had
developed a process where a detailed questionnaire would be
sent out to branches required to be answered by the firms, and
it got into areas that are involved here dealing with LOAs and
post office boxes. That was supposed to be, under the
procedures, followed up twice a year by branch office visits
from this new supervisory structure that was put in place.
There was also a representation that the branch office
manager's correspondence would be put in a separate file that
would be reviewed monthly. And there was a general
representation that all of the procedures put in place now had
adequately enhanced supervision. There was a representation
that the Compliance Department had enhanced supervision
generally by, among other things, adding resources.
So one of the things that we are looking at carefully in
our investigation now is whether these procedures were number
one, actually put in place; number two, if put in place,
maintained; and, number three, even if the procedures were put
in place, were they adequately implemented? Sometimes we see
procedures, and they are a great looking set of procedures, but
implementation is not carried out.
So this is what we are looking at now in the course of our
investigation. We required this enhanced review as a part of
that enforcement proceeding, and we received assurances not
only from the outside law firm, but the report was filed and it
was certified by both the Board of Directors and the CEO that
these procedures had been put in place.
Chairman Kelly. Thank you, Mr. Doherty.
Mr. Doherty. Now, we are concerned that in light of this,
the Gruttadauria activities were continued, and that is very
much the focus of our investigation.
Chairman Kelly. Thank you, Mr. Doherty. One of the things
that really concerns me about this case is it hasn't been just
Mr. Gruttadauria. There have been other cases. We need to do as
much as we can to have you do what you need to do to put the
public's trust back into the system.
So with that being said, I am going to turn to my
colleague, Ms. Tubbs Jones.
Mrs. Jones of Ohio. Thank you, Madam Chairwoman.
Mr. Fazio, unfortunately, we only have five minutes to
question. But it would be a shame that you wouldn't have a
couple--another opportunity to be heard, at least briefly. Can
you tell me, looking back, sir, what was it that engendered Mr.
Gruttadauria to you? If we were going to talk to other senior
citizens like you and Mrs. Stout, what would you tell them to
look out for?
Mr. Fazio. Do you mean now that--
Mrs. Jones of Ohio. Yes, sir.
Mr. Fazio. --this happened?
Mrs. Jones of Ohio. Looking back, in hindsight, sir.
Mr. Fazio. Well, I would say that you need to talk to
somebody above the branch manager in New York and check if, in
fact, any brokerage company person ever called any investor
when there was an address change to check it out, and to be
careful because things can be done with these phony statements
that we are learning and we know now.
And did any person ever call any customer? I never got a
call from anyone else. I never did. And these numbers were
changed, and my signature was forged, and so forth, to change
them. Never got a call from anyone, and I didn't know what was
going on. I really didn't. I didn't know that these box numbers
even existed until now, until all of this--everything came up.
Mrs. Jones of Ohio. But there was something about Mr.
Gruttadauria that caused you to place some trust in him. But
what I am asking you is: with regard to personality, or
whatever, what would you say to another senior citizen who
might have been--might be contacted by a broker?
Mr. Fazio. Well, I would say that sometimes you have got to
watch your closest friends. He was a very close friend. I told
you I treated him like he was my son. That is how close we
were.
Mrs. Jones of Ohio. Okay.
Mr. Fazio. And you have got to be careful, and that is all
you can do.
Mrs. Jones of Ohio. Okay.
Mr. Fazio. But mainly is that companies themselves have to
check out their people. You know, you can't do it with the
compliance officer, as I pointed out, in the same office
reporting to the manager. You have got to do it where the
compliance officer reports to somebody else above the manager,
somebody in New York to check all these things out.
Mrs. Jones of Ohio. Thank you.
Mrs. Stout, a short answer if I could get one from you as
well. Go ahead.
Mrs. Stout. Well, I wish that I had been smart enough to
analyze why did I have checks with DeGrandis for the signature.
Now, it should have been Lehman or Cowen. Instead, it was
someone else. I had my own tax person. Why would I be having
that firm as a tax representative?
Mrs. Jones of Ohio. For the record, tell people who
DeGrandis is, Mrs. Stout.
Mrs. Stout. Well, I think that they are a tax firm working
in Ohio.
Mrs. Jones of Ohio. Well, this was someone that Mr.
Gruttadauria represented or expected that you might use for
your tax purposes, an attorney in Cleveland, right?
Mrs. Stout. He might have, but I was--never even hinted to
say I would like to have or needed--
Mrs. Jones of Ohio. Okay. Anything else you would say to
other seniors who might be considering doing some investment,
what they should look out for from your own perspective?
Mrs. Stout. Well, when they start saying--I wanted to have
online for my--so I could watch each day. When I called to ask,
he said, ``Oh, no, we do not do that. I will not be harassed.''
When you start having--saying, ``I won't do this. I won't do
that,'' that is a red flag. Watch. And in the future, don't
have that person--he said, ``If this is the way that you feel
so strongly, then I will get you another broker.'' I was--
Mrs. Jones of Ohio. And you should have said, ``Then, get
me another one,'' right?
Mrs. Stout. Well, and so what I should have done--you know,
I kind of hemmed and hawed there for a minute, and he said, ``I
will tell you what I will do. I will send you the symbols, but
this is against my principles.''
Mrs. Jones of Ohio. Okay.
Mrs. Stout. You know what? It isn't his principles, it is
mine, that I should be thinking about. And that was a mistake.
You know what? You should come back on your own intuition. I
did not. I was--I am like Carl. I thought he was like my son,
and I trusted the firm. After all, it is a good firm. I thought
he was in Chicago. I never knew that he was in Ohio. Had no
idea.
He visited me, told me about--took me out for dinner, told
me about the one daughter that was a candy striper at--
Mrs. Jones of Ohio. He drew you in, in other words. He drew
you in to his confidence.
Mrs. Stout. Oh, honey, he was right there.
[Laughter.]
Mrs. Jones of Ohio. Thank you, Mrs. Stout.
Let me go to Mr. Doherty from the New York Stock Exchange.
Can you tell us how often brokerage firms incur charges like
the one that was brought against Cowen & Company in 1998 with
regard to failure to supervise branch manager officers,
etcetera?
Mr. Doherty. Well, let me answer more broadly.
Mrs. Jones of Ohio. Okay.
Mr. Doherty. In a typical year, our enforcement program
will bring about 200 formal enforcement proceedings. The large
majority of those charged are individuals. But in a typical
year, I would estimate 20 or 25 member firms themselves are
charged as Cowen was in the example we have heard about.
Mrs. Jones of Ohio. And of the--go ahead. I am sorry.
Mr. Doherty. Well, those charges range all the way from
purely financial and operational kinds of things, a net capital
violation, for instance, to, in some cases, inadequate
supervisory procedures. And then some of the inadequate
supervisory procedures cases relate to sales practice issues.
Mrs. Jones of Ohio. Well, a firm signs up to be part of the
New York Stock Exchange, what commitments do they make?
Mr. Doherty. Well, they make a commitment to not only abide
by the federal securities laws, but they make a commitment to
abide by the New York Stock Exchange's rules, which really
impose on the firms not only a variety of particular rules but,
importantly, our rules require that our firms operate
consistent with ethical standards. So that it is a level of
conduct which could be violated that doesn't reach a violation
of the federal securities laws.
So our rules require such things as--or preclude conduct
inconsistent with just and equitable principles of trade, and
the like, ethical standards.
Mrs. Jones of Ohio. Do you have subpoena power as the New
York Stock Exchange?
Mr. Doherty. We don't--
Mrs. Jones of Ohio. To your members.
Mr. Doherty. We don't have subpoena power, but--and our
jurisdiction is limited to our members and employees, people
associated. But we--
Mrs. Jones of Ohio. So if I fail to agree to provide you
information or cooperate, what do you do to me?
Mr. Doherty. Well, with respect to the people we have
jurisdiction over, we have something better than--
Mrs. Jones of Ohio. That is what I meant, if I were a
member. Okay.
Mr. Doherty. And that is we have a rule that requires that
our members and people associated comply with our reasonable
requests for information in our investigations and that is the
provision which we have used to charge three people in this
particular investigation. We use it often, and the usual
consequence is that people are barred from the industry until
they comply or perhaps barred after a certain period of time if
they don't. So there are significant consequences.
Mrs. Jones of Ohio. Two shorter questions with hopefully
shorter answers. You have heard Mr. Fazio, Mrs. Stout, and
others say that the reason they invested with these companies
was because of their reputation long term. Do you, as the Stock
Exchange, treat people who have been long-term members any
differently than you treat newer members to the Stock Exchange?
Mr. Doherty. No. We apply the same standards to everyone.
We sue the big firms and the small firms equally.
Mrs. Jones of Ohio. Do you treat sanctioned firms any
differently than you treat non-sanctioned firms?
Mr. Doherty. The fact that a person or a firm had engaged
in violative activity previously would be considered in the
size of the sanction or punishment that would be imposed if
there was another violation.
Mrs. Jones of Ohio. For example, in '98, when you
sanctioned Cowen & Company, what was the follow up after that
sanction?
Mr. Doherty. Well, we haven't--that is the last enforcement
proceeding--
Mrs. Jones of Ohio. Okay.
Mr. Doherty. --that we initiated against Cowen to my
knowledge.
Mrs. Jones of Ohio. But who, then, is responsible for
overseeing whether or not they have complied with the sanction
that you impose?
Mr. Doherty. Well, in the first instance, the firm has a
continuing responsibility to, under our rules, and as Ms.
Richards said, to run their business operation in a way that
complies with the rules. Secondly, our examiners will typically
go back into a member firm in the follow-on years where they
have found problems to do a review to ensure that the problems
have been corrected.
Mrs. Jones of Ohio. Did you go back to Cowen after '98?
Mr. Doherty. Yes. We went--
Mrs. Jones of Ohio. And who went back? And what did you
find?
Mr. Doherty. Our examiners went back in and reviewed for
compliance with many of the exceptions that were found, and
they found no deficiencies that they felt were worthy of
referring to the enforcement program.
Mrs. Jones of Ohio. I am out of time, but I--we are going
to have another round. Is that correct?
Chairman Kelly. We will see if that is possible.
Mrs. Jones of Ohio. Because I have a lot of questions for
Ms. Richards, but thank you, Madam Chairwoman.
Chairman Kelly. Ms. Tubbs Jones, I am going to hold the
record open for 30 days for questions and submitted answers for
all members of the committee, because some of the members can't
be here today. So by all means, if you have further questions
of this panel, you may submit them, and we can expect their
responses within 30 days. So feel free to do that, if we are
not able to do a second round here.
We turn now to my colleague, Mr. Ney. Mr. Ney, are you
ready?
Mr. Ney. Thank you, Madam Chairwoman.
I had a question, Mr. Doherty. A securities attorney quoted
in the Cleveland Plain Dealer story said that a turnover rate
of six times a year should raise a red flag, and that was
reported in the PD. In your opinion, if the SEC could have told
you the level of commissions and a turnover rate of 18 times in
six months, do you think the Exchange might have wanted to take
a more closer look at Gruttadauria's accounts?
Mr. Doherty. I think that we would have--it would have been
a red flag, and it would have been something that we would have
looked at carefully. I can't tell you that we would have done
it any differently from what the SEC did. In hearing Ms.
Richards' testimony, it sounds as though they brought to bear
the same kind of analysis that we would have.
Mr. Ney. Another question I had would be for Ms. Richards
and Mr. Doherty. Mr. Gruttadauria apparently created these
phony account statements on his own computer outside of the
office system. How can that be prevented in the future, that
they could be--or can it? Just some thoughts from both of you
on that.
Ms. Richards. One of the things that we recommend in our
testimony is that broker-dealer firms maintain very tight
control over blank account statements and other account
documents of the firm, so that registered representatives and
other unauthorized employees can't get hold of them, doctor
them up, and send them out.
Another thing that many firms are doing now is creating
account statements that are very difficult to duplicate. They
have holograms or watermarks or special indicia on the
original, so that it makes it easier to detect a forgery. So I
think control over the actual sending of the account statements
by brokerage firms is terribly important.
Mr. Doherty. If I could add that in 1999 we added an
element to our exam program that required our examiners to do a
careful review of this very area, to look to see whether there
were any personal computers being used by any salesmen in the
office, and to do an examination of what procedures the firms
had in place to supervise the use of those personal computers.
And that is an area we are very much concerned about with
electronic communications and use of the internet by registered
reps, and we have brought a bunch of enforcement cases against
registered reps in that area. This is something that we did at
least two or three years ago in terms of extending our exam
program.
Mr. Ney. The other question I wanted to ask someone I
guess--if people are receiving false statements for a number of
years, and they have prepared their taxes, wouldn't Lehman
Brothers have to send notification of earnings, and, therefore,
the people overpaid their taxes that are sitting here? I don't
know who wants to reflect on that, but--
Mrs. Stout. I don't really see how it could be. I received
the 1099s, my monthly statements--
Chairman Kelly. Ma'am, please turn on your microphone.
Somehow it has gotten turned off. Pull it closer to your mouth,
and then we can all hear what you say.
Mrs. Stout. All right.
Chairman Kelly. Thank you.
Mrs. Stout. I did receive the 1099s, my monthly statements.
There was no other way that I figure that I could have been
alerted.
Mr. Ney. Well, I guess my question--and probably maybe the
other panel can answer it--my question is geared towards if
you're--you know, you're receiving these false statements.
Lehman Brothers, I assume, had to be responsible for
notification to IRS of, you know, the real account. So,
therefore, you know, I guess there was no IRS catching the
difference, which would have alerted you early. I guess there
is no mechanism.
But, obviously, Lehman Brothers had to have sent those in.
Isn't that correct? Isn't that the way it works? So it would
have showed to the IRS, you have Mrs. Stout, here is how much
she made, but she shows she made--and over a period of 10 years
or nine, surely that should have gotten caught somewhere, I
would assume, by IRS.
Mrs. Stout. Well--
Mr. Ney. Although maybe I shouldn't--
Mrs. Stout. --maybe I could come back and say now I had
Microsoft, I had Cisco. That was--it would grow. I had--I
started out with 750 shares. When I got my last statement, I
had 12,000 of one and 27,000 of another, which showed that I
had all of that, but it wouldn't show on my income tax, because
it was still in the firm, and not--
Mr. Ney. I have gone past my time. Maybe later on somebody
can clarify, was he sending false statements to Lehman
Brothers, to the IRS? No. Right? Yes? No.
Chairman Kelly. Go ahead and ask that question. I will give
you--
Mr. Ney. Thank you. If you could--
Chairman Kelly. --a little more time. Ms. Richards, if you
could answer that.
Ms. Richards. I was just going to say our investigation is
ongoing. I think if the firm was sending accurate 1099s to the
addresses on file, for many of these customers those were post
office boxes. So they would not be getting the accurate 1099s.
Mr. Ney. But they went to the IRS.
Ms. Richards. Yes.
Mr. Ney. Right?
Ms. Richards. Yes. I would think that--yes.
Mr. Ney. So it should show different what Mrs. Stout was
reporting from the false--and then what the IRS was getting
from Lehman Brothers. It should show a difference, I think.
Ms. Richards. There would be a discrepancy. I just don't--I
don't know what the IRS--
Mr. Ney. I mean, it is important to know whether that--I
mean, I feel sorry for these people that have been burned. I am
just wondering what system should have caught that.
Thanks very letting me exceed my time.
Chairman Kelly. Perfectly all right. It is a legitimate
question. It needs answering. It raises a lot of issues, and it
is probably part of the ongoing judicial investigation.
Now we go to Mr. LaTourette.
Mr. LaTourette. You caught me by surprise, Madam Chairman.
I thought Mr. Cantor was still here.
Mrs. Stout, since this story broke, has anyone other than
Mr. Gruttadauria from Lehman Brothers come to visit you in
Elgin, Illinois?
Mrs. Stout. Yes. I had representatives of Lehman.
Mr. LaTourette. Right. Can you tell us about that exchange
or what happened when they came to see you?
Mrs. Stout. I beg your pardon?
Mr. LaTourette. What was the purpose for which they came to
visit you, and what happened?
Mrs. Stout. Well, I had called the office and wanted to
have an explanation, and they, I assume, decided they wanted to
come I think maybe to check to see if I was going to be an easy
customer, if they would be able to hoodwink me, and I--and they
left. I had no information from them.
Mr. LaTourette. Did you ask them about your money? I mean,
what--
Mrs. Stout. Oh, yes, I did. And I asked if there was a
chance that I would be getting it back.
Mr. LaTourette. And what did they tell you?
Mrs. Stout. No answer.
Mr. LaTourette. Okay. When Mr. Fazio comes back, I have a
couple of questions for him.
But, Ms. Richards, I am going to ask my legislative
assistant to hand you a document that the Chairwoman was
talking to, and this is--when you were indicating before the--
and, Mrs. Stout, just back to you, Mrs. Cuneo is your sister,
right?
Mrs. Stout. Yes.
Mr. LaTourette. Your sister.
Mrs. Stout. Yes.
Mr. LaTourette. And that was--Mrs. Cuneo's account was the
subject of the 1993 complaint, Ms. Richards, is that the
anonymous complaint, the--
Mrs. Stout. I am not sure, but it could be.
Mr. LaTourette. I am asking Ms. Richards. Cuneo was the
investor involved in the 1993 anonymous complaint?
Ms. Richards. The identity of the accounts that we examine
are typically not public.
Mr. LaTourette. Right. But they will be when you comply
with Mrs. Kelly's request. And I think it is Mrs. Stout's
sister that was ripped off in 1993, and we will determine that.
I have put in front of you a document that is an account
belonging to a fellow by the name of Dominic A. Visconsi, Sr.,
and it goes from '92 to '96. And at the bottom--I think Mr. Ney
asked you--it is my understanding under federal law, and also
S.G. Cowen's own internal manual, that a turnover ratio of six
gives rise to a conclusive presumption of excessive trading or
churning. Is that your understanding, or am I mistaken?
Ms. Richards. We would actually look very hard at any
account that had a turnover ratio of less than six. We would
look at an account that had a turnover--an annualized turnover
ratio of two to three. We would then focus hard on those
accounts.
Mr. LaTourette. What about the ones that are turned over
more than six times?
Ms. Richards. Well, certainly, those would trigger our
attention.
Mr. LaTourette. Well, in the document I have put in front
of you, in 1992, Mr. Visconsi's account, with an average equity
of $416,000, was charged commissions of $113,000, and turned
over 18 times. Would you consider that to be unusual activity
worthy of your examination, had you known about it?
Ms. Richards. Absolutely.
Mr. LaTourette. And, likewise, in 1993, average equity of
$447,000, commissions of $221,000, and a turnover ratio of 34
times. I would imagine that would grab your attention as well,
had you known about it.
Ms. Richards. Yes.
Mr. LaTourette. And, Mr. Fazio, I have had a chart made of
an account that your lawyer was kind enough to give me last
night. If we could put the chart up on the easel. It is your
account 00-00068. And the year that we have highlighted is
1990, and I would just like you to take a look at it. And, one,
does that look familiar to you? Do I read it right that, in
1990, your account had an average equity of $103,000 roughly,
that the commissions charged on it were $67,471.70, and the
turnover ratio was a little over 15 times, is that a correct
reading?
Mr. Fazio. That is correct.
Chairman Kelly. Excuse me. I want to know if you would like
to have that entered into the record.
Mr. LaTourette. Yes, please.
Chairman Kelly. So moved.
[The following information was subsequently furnished by
Mr. Carl Fazio witness] for the hearing record.]
Mr. LaTourette. And, Ms. Richards, likewise, with the
Visconsi account, and we are, again, in the same time period as
your investigation in 1993 of the account we believe was owned
by Mrs. Stout's sister, would you find the information that is
on that board to be worthy of your attention and examination?
Mrs. Stout. I am sorry. I did not--
Mr. LaTourette. No, no, I was talking to Ms. Richards. I am
sorry, Ms. Stout.
Ms. Richards. We would definitely scrutinize an account
with that kind of turnover ratio. I think it is important to
note that we focus on firms' exception reports, which would
typically flag accounts with turnover ratios of certainly that
high. And then we would drill down and focus specifically on
those accounts.
So if the firm's exception reports were accurately
identifying accounts with those kinds of turnover ratios, we
would drill down very hard and focus on them.
Mr. LaTourette. And, lastly, let me ask you, it is my
understanding, in response to the questions by the Chairwoman,
that your investigators made a judgment call not to talk to the
investor in 1993 in that investigation. And basically--and,
Mrs. Stout, let me come back to you, who was the executor of
your sister's estate? Do you recall?
Mrs. Stout. Frank.
Mr. LaTourette. Frank Gruttadauria. Doesn't that create
sort of, Ms. Richards, a closed loop? If you go and you talk to
Mr. Gruttadauria, who apparently is trusted by people like Mr.
Fazio and Mrs. Stout, and apparently her sister, and you have
an account that has been turned over 18 times in six months,
charged commissions of $39,000 on an equity of $96,000, does
due diligence or an appropriate investigation stop with a guy
like Frank Gruttadauria? I mean, don't we have an obligation to
go out and talk to somebody else besides the thief?
Ms. Richards. Well, again, focusing on the information that
the examiner had before him at the time, it was a judgment
call. And one of the critical factors that the examiner relied
on was whether or not the investor that owned the account had
complained. And, in fact, this investor had never complained
about the trading in her account.
Looking back on it now, with all that we know about what
Mr. Gruttadauria did and what he was capable of, yes, I
certainly wish we would have talked to the customer. But, I
mean, now, looking back, I don't know what the customer would
have said.
Mr. LaTourette. Of course not.
Ms. Richards. Truly, I don't know if, looking back on it
now, if the customer wished to engage in frequent trading and
herself directed the trading, as we were told by the firm.
Mr. LaTourette. But I think if you put the '93 account
together with the Visconsi account together with the Fazio
account, I mean, something smells pretty bad here, and perhaps
we should have talked to additional people. And I had a
question and now it is out of my head.
Mrs. Stout, back to you, let me--when Lehman Brothers
visited you, did you have the impression that it was an attempt
to get you to settle any claim you might have against them?
Mrs. Stout. No.
Mr. LaTourette. Okay. Did they inquire as to whether or not
you were represented to counsel, whether you had a lawyer?
Mrs. Stout. I had not had a chance to get counsel.
Mr. LaTourette. Okay. And lastly, Ms. Richards--and I
appreciate the Chair's indulgence--was the investigation
conducted in 1993 shared with S.G. Cowen?
Ms. Richards. S.G. Cowen compliance personnel were in the
room when we interviewed Mr. Gruttadauria, and when we asked
questions about the accounts and the exception reports. So they
were very well aware of what we were focused on.
Mr. LaTourette. Would your investigative file have been
available to Lehman Brothers when they were conducting their
due diligence when they purchased the retail business of S.G.
Cowen in the year 2000?
Ms. Richards. No, because the examination didn't result in
conclusive findings of violations. There was no deficiency
letter sent to the firm.
Mr. LaTourette. Would your investigative file have been
shared with Mr. Doherty in the Enforcement Division of the New
York Stock Exchange?
Ms. Richards. We share examination reports with the SROs
whenever it's relevant for either party. But in this case, it
wasn't.
Mr. LaTourette. And I was going to ask Mr. Doherty, before
reading it in the newspaper, being advised during the course of
these proceedings, any idea that Mr. Gruttadauria had been the
subject of this anonymous complaint in 1993?
Was there any idea by you, Mr. Doherty, that Mr.
Gruttadauria had been the subject of this 1993 complaint?
Mr. Doherty. Not to my knowledge, no.
Mr. LaTourette. Thank you very much, Madame Chairman.
Chairman Kelly. Thank you. Mr. Inslee, do you have
questions?
Mr. Inslee. If I may, Madame Chair, I'd like to yield to my
colleague from Ohio my time in this regard. She's been doing
excellent work on it.
Chairman Kelly. Thank you.
Ms. Jones. Thank you, Mr. Inslee. I want to start and
continue the line of questioning from Mr. LaTourette, Ms.
Richards.
In 1993, you got an anonymous complaint. You went and
reviewed the record. Under all anonymous complaints, is it that
you never talked to the customer?
Ms. Richards. No, that certainly is not the policy. I think
our policy currently--
Ms. Jones. Take me back to 1993, not currently.
Ms. Richards. In 1993, our policy would have been to
contact a customer if there were any loose ends, if there was
any indication.
Ms. Jones. But who better than the customer than to tell
you or to signal to you of some difficulty?
Ms. Richards. Well, in fact, the examiner made the decision
not to contact the customer because he was focused on the fact
that the customer had never complained to the firm, the fact
that the trades appeared to be directed by the customer and the
fact that this customer appeared to be an experienced trader.
Ms. Jones. Appearances are deceptive. Would you agree with
me on that, Ms. Richards?
Ms. Richards. This was according to the new account form
that the customer would have filled out with the brokerage
firm. The customer would have indicated to the brokerage firm
his or her net worth, his or her investment experience, his or
her investment--
Ms. Jones. Back up a minute. You said it appeared that the
customer signed the form. What I'm trying to get to is
appearances are deceptive. We're sitting here with people like
Mr. Fazio, Mrs. Stout, Mr. Glazier. Under the appearances
invested with Mr. Gruttadauria, you were the examination folk.
It's incredible to me that--I'm a former prosecutor, you're an
examiner. You go after the witnesses. The best witness would be
the customer that you would talk with them to find out in any
instance, would it not be?
Ms. Richards. Sitting here now, I wish we would have called
the customer, absolutely. I don't know what the customer would
have said.
Ms. Jones. We never know what anybody is going to say.
Ms. Richards. But sitting here now, I certainly wish we
would have talked to the customer, yes.
Ms. Jones. So now the rules, seeing as we're now trying to
get so instances like this don't happen again, you talk to the
customer now?
Ms. Richards. Yes, we have a much more liberal policy on
when the government contacts the customer about a particular
account, absolutely.
There's another change, if I could--
Ms. Jones. Please.
Ms. Richards. There's another change in the law that I
think will be helpful in preventing similar situations like
this. Under new rules that were adopted by the Commission a
couple of months ago. The information that I described on a new
account form about the customers' name, address, investment
objectives, net worth, that information now will have to be
sent to the customer for verification, so that will prohibit a
registered representative from falsifying information on the
new account form and I think that's a terribly important--
Ms. Jones. It won't prohibit falsification.
Ms. Richards. Well, the registered representative will be
out of the picture. The firm will send that statement to the
customer and the customer can look at it and say--
Ms. Jones. Where does the firm get the customer's address?
Ms. Richards. The firm would get the customer's address
from the customer.
Ms. Jones. So you're saying that every firm now will have a
direct contact with a customer even though there is another
representative involved in the process?
Ms. Richards. Yes, the firm itself will communicate
directly with the customer and the customer will then be able
to verify yes, that's my name, that's my address or no, it's
not or that's not my investment objective, that's not my net
worth. It will make it much more difficult for registered reps
to lie about those things--
Ms. Jones. And what caused you to make this rule change in
the last two months?
Ms. Richards. It had been in the works for some period of
time. We worked very closely with the state securities
regulators who suggested to us that this was a change that
needed to be made to prevent theft by brokers. The Commission
agreed with it and made the change a couple of months ago.
Ms. Jones. What other changes have you made to assure an
investing public that you are going to do your job?
Ms. Richards. Well, there's another change imposed in the
same books and records rule that I think Mr. Fazio alluded to
and that is the protection against registered representatives
opening post office boxes in their control. The new rule would
require that brokerage firms send a change of address
confirmation to the old address and the new address. That, I
think, will go a long way towards preventing registered
representatives from creating these fictitious post office
boxes, because the customer will get a notice from the firm
that says have you or have you not changed your address to a
post office box? I think that's an important protection.
Ms. Jones. Did you see all of these events that are
occurring and I look at them, oh wow, okay--I can finish that
question or not? No, okay, I won't. I'll go back.
Chairman Kelly. Mr. Tiberi. We'll let you hold that thought
and come back.
Mr. Tiberi.
Mr. Tiberi. Thank you. Thank you, Madame Chairwoman. Just a
couple of questions. Ms. Richards, of your total investigative
force meaning like attorneys, investigators, supervisor
attorneys, senior trial counsels, how many are employed in the
Northeast Region in New York?
Ms. Richards. The Northeast Region is comprised of both
enforcement attorneys as well as examiners and accountants who
conduct examinations of broker dealers, investment advisers,
and investment companies. I don't know offhand the total number
of staff in the New York office, but I'm happy to provide that
to you.
Mr. Tiberi. That would be great. My understanding is is
that the bulk of the employees who do criminal investigations,
the staff attorneys are located here in Washington, D.C. and
they're sent out rather than having a stronger presence
throughout the United States. And it would seem to me that
maybe that has created a problem.
Ms. Richards. We have 11 regions and districts in major
metropolitan centers which are staffed by not only enforcement
attorneys who bring enforcement cases, but also in my office,
by examiners and accountants who conduct examinations of
registered firms in their regions and districts.
Here in Washington in the examination program, we have a
staff of about 100 accountants, examiners and attorneys who
also conduct examinations and assist in the examinations
conducted by the field offices.
Mr. Tiberi. You'll provide that information to us?
Ms. Richards. Sure.
Mr. Tiberi. Thank you. Ms. Stout, you mentioned in your
testimony that with respect to on-line services that Mr.
Gruttadauria was dissuading you from, in your own words,
accessing your on-line account. How did he do that? How did he
dissuade you from doing that?
Ms. Stout. He really had not persuaded me not to. I was
still insistent on doing it, but when I called--he told me that
he had made up his mind when he went into business that he
would never have any on-line. He would not be harassed by his
clients and I said I have never harassed you, Frank. I would
like to do it. It's a joy for me to learn new things and he
said if you feel so strongly I will have to get you another
broker. And I thought, well, I don't know. And I kind of led
him on and he said I'll tell you what, Golda, I've know you for
all these years. I will send you the symbols and I thought all
right. But I didn't get the symbols. And then I was going to
call and say forget it.
Mr. Tiberi. Over the years you received monthly statements,
Ms. Stout?
Ms. Stout. Yes.
Mr. Tiberi. I assumed you paid taxes on those statements?
Ms. Stout. Oh, yes, I did.
Mr. Tiberi. How much tax do you believe you paid in the end
on money that you didn't earn?
Ms. Stout. Well, two years ago I almost went into
hysterics. I ended up paying $32,000 to the government. I paid
quite a little bit to the state, plus I had been paying
quarterly for the estimated. Now that will give you an idea of
what I did do.
Mr. Tiberi. Ms. Stout, did either Cowen or Lehman offer to
take responsibility?
Ms. Stout. No.
Mr. Tiberi. Okay. Has either company offered to make up the
losses incurred?
Ms. Stout. No.
Mr. Tiberi. Mr. Fazio, has either company offered to make
up losses that you incurred?
Mr. Fazio. No. They have not offered anything.
Mr. Tiberi. And neither Cowen or Lehman will take
responsibility, Mr. Fazio?
Mr. Fazio. No, they have not. I asked for some substance of
some kind until we settle it. They didn't offer a dime,
nothing.
Mr. Tiberi. Madam Chair, I'd like to yield the balance of
my time to Mr. LaTourette.
Mr. LaTourette. Thank you very much, Mr. Tiberi, for the
courtesy on the little less than a minute that you have
remaining.
Mr. Fazio, I wanted to reference before we go into other
matters, there was a rather obnoxious column in the Cleveland
Plain Dealer a couple of months ago and it's unusual for the
Cleveland Plain Dealer, it's a fine newspaper, but it suggested
that those of you who lost money were either sloppy, greedy or
inattentive and that perhaps participated in your own demise.
And I would just like you, sir, to indicate for the purposes of
the record, were you a sloppy, inattentive or a greedy
investor?
Mr. Fazio. Absolutely not. I kept track of everything I did
and checked it against the statements and everything balanced.
If it didn't, he would correct it. I was not a sloppy investor
and this person, I was so mad when I read that article I wanted
to cancel the Plain Dealer.
Mr. LaTourette. The statements that you received from Mr.
Gruttadauria, did they mirror the notes and notations that
you--
Mr. Fazio. Yes, they mirrored my investments as I kept
track in several notebooks of my trades. They did. I want to
add one other thing, that in answer to another question, the
customer did not sign the form. When Lehman took over, I'm the
client, it was forged. My name was forged. Customers had no way
of knowing about the trades, the excessive trades or anything
else. Signatures were forged.
Mr. LaTourette. Thank you very much and thank you again,
Mr. Tiberi, for your courtesy.
Chairman Kelly. Thank you, Mr. LaTourette. Mr. Clay, have
you questions?
Mr. Clay. Thank you, Madame Chair. Let me thank you for
conducting this hearing as well as I'd like to ask unanimous
consent to submit my statement in the record.
Chairman Kelly. So moved.
Mr. Clay. And yield the balance of my time to Ms. Jones.
Ms. Jones. Thank you, Mr. Clay. Ladies and gentlemen, I've
been able to twist all of my colleagues' arms to tell them this
is my jurisdiction, give me your time and I thank each of them
for being willing to do so.
For the record, Madame Chairwoman, we had asked Mr. Samuel
Glazier to come and testify and under advice of his counsel, he
chose not to, but he is seated here in the room today and we do
have a letter from Mr. Glazier's attorney that I'd like to
submit for the record, so that everybody will understand why it
was he chose not to testify.
[The following information was subsequently furnished by
Hon. Stephanie Tubbs Jones for the hearing record.]
Chairman Kelly. So moved.
Ms. Jones. Great. Thank you. Let me see, where did I leave
off.
Let me go back to you, Ms. Richards. Tell us how you
perceive and Mr. Doherty, you can answer this question, that
you, the Stock Exchange, and you the SEC, are going to
collaborate to see that Mr. Glazier and Mr. Fazio and Ms. Stout
and Mr. Stanton and others may be able to get some relief?
Ms. Richards. Well, in our enforcement action that we filed
against Mr. Gruttadauria, we asked for disgorgement of any and
all ill-gotten gains. Any ill-gotten--
Ms. Jones. Just for the record, why don't you tell us what
disgorgement is, okay?
Ms. Richards. That's a request to the Court that Mr.
Gruttadauria be ordered by the Court to turn over any monies or
property that he may have obtained unlawfully.
Ms. Jones. And so has he been enjoined from disposing of
those assets, have you corralled those assets for purposes of
the possible victims?
Ms. Richards. We asked for, at the time we filed the
complaint, an asset freeze, a freeze of all of his accounts and
the Court entered that order.
Ms. Jones. So who is it, if you can answer this question,
responsible for corralling--you know, we generally set up
someone who has oversight over such assets. Has someone been
assigned to do that and are you able to tell us for the record
what the value of those assets may be at this time?
Ms. Richards. As far as the value of the assets, I think
it's too early to know. The Commission's enforcement staff is
still in the midst of taking discovery and very actively
investigating this matter, not only as to Mr. Gruttadauria, but
also as to other individuals who may have assisted or
participated in the fraud along with him.
Ms. Jones. In light of the fact that Mr. Gruttadauria was
employed by Lehman Brothers had you corralled any of Lehman's
assets in order to be able to satisfy the possible losses of
these victims?
Ms. Richards. Under the securities laws' framework, there
is a remedy of arbitration. Each customer can arbitrate his or
her dispute with a brokerage firm. In addition, I know that a
number of customers are considering taking action in Federal
Court and State Court.
Ms. Jones. Let me ask my question again, in light of the
fact that Mr. Gruttadauria was employed by Lehman Brothers,
have you corralled any of the assets of the Lehman Brothers or
SG Cowen in order to satisfy the losses of the victims of this
particular incident?
Ms. Richards. The Commission doesn't have authority to
obtain monies directly on behalf of investors. Typically, when
we obtain disgorgement of ill-gotten gains, we would then seek
the Court's approval to disperse those moneys back to investors
who were defrauded.
Ms. Jones. Isn't it conceivable, Ms. Richards, that Mr.
Gruttadauria had ill-gotten gains, Lehman Brothers also had
ill-gotten gains, so in fact, their assets ought to be
corralled? Let me cut if off. It's conceivable that if
Gruttadauria got ill-gotten gains, so did Lehman Brothers,
because it's based on a commission. Is that true?
Ms. Richards. The Commission is continuing to investigate
the conduct by the two brokerage firms that employed him.
Ms. Jones. So you're saying the SEC has no authority to
deal with Lehman Brothers as they're dealing with Gruttadauria
in term of assets?
Ms. Richards. The Commission has the authority to bring
enforcement actions against both of those firms and we are very
actively investigating them. Both of these firms are still in
business. Both of these firms are healthy. They have adequate
net capital. They have adequate reserves. This is not a
situation--
Ms. Jones. How long does it take to declare bankruptcy, Ms.
Richards?
Ms. Richards. I don't know. These firms have adequate
capital to continue to do business.
Ms. Jones. I'm trying to get my staffer to find me a
newspaper article where Lehman is, in fact, claiming the
possibility that so many suits to cause them to be placed in
financial difficulty. Have you seen that article?
Ms. Richards. I saw an article where they disclosed that
the firm was taking a reserve against the potential for
lawsuits.
Ms. Jones. So what does that tell you?
Ms. Richards. It tells me they're starting to set aside
money for the possibility that they'll have to make some of the
victims whole.
Ms. Jones. So you're saying to the world on behalf of the
SEC that Lehman Brothers is going to be in a position to settle
or pay up all these folks who have lost money. Help her out,
come on.
Mr. Doherty. Could I add something? Since we're
investigating this matter right now, I'd rather not comment on
what we have in mind here. But I can tell you that when we get
involved in an investigation and we see customers who have been
damaged and have had money stolen, very much a high priority of
our concern before we resolve that enforcement action is that
those customers get taken care of and dealt with fairly by our
member firms.
Ms. Jones. So are you saying that the stock exchange is
going to have the back of Lehman Brothers for satisfying the
claims of all these folks?
Mr. Doherty. What I'm saying is that since I can't comment
on what we're going to do in this case, I'll tell you what
we've always done and what has been our consistent practice
where investors have had their money stolen by an employee of a
member firm. We have made it very clear to our member firms
that we expect them to deal fairly with their customers and
reimburse their customers. They understand that and I cannot
think of a case in the last 10 years where an employee of one
of our member firms has stolen money and that that customer has
not been taken care of by the member firm.
Ms. Jones. Thank you, Madame Chairwoman. I appreciate the
time.
Chairman Kelly. Thank you. Ms. Richards and Mr. Doherty,
I'd like an answer to this question. Do either of your
institutions have any rules about the appropriateness of branch
managers or brokers who supervise their compliance officers? Do
either of you have any rule in existence now and did you back a
couple of years ago? How long has this rule been in place?
Ms. Richards, do you want to answer that first and then
we'll go to Mr Doherty?
Ms. Richards. Yes, as I said, broker-dealers have a duty to
reasonably supervise. We would not consider a reasonable
supervisory system a structure in which supervision was had by
a subordinate. That to us would not reflect a reasonable system
of supervision. Supervision must be independent to be
effective, so we would look to someone outside of the branch
manager's chain of command to supervise that branch manager's
activities.
I would note that that's something that was specifically
set forth in my testimony as one of the practices that we
intend to focus on very hard in our examinations.
Mr. LaTourette. Will you yield to me just for that, on that
point?
Chairman Kelly. Of course.
Mr. LaTourette. In this situation where Mr. Semanek is the
compliance officer on behalf of Lehman Brothers and he's a
subordinate of Mr. Gruttadauria, are you indicating that that
is a nonsatisfactory arrangement?
Ms. Richards. I can't comment on the facts of this
particular case because that very situation is under
investigation by our enforcement staff, but a situation in
which a subordinate of a branch manager is supervising that
branch manager's activity, in my view, doesn't reflect a
reasonable system of independence.
Mr. LaTourette. With the Chairwoman's indulgence because I
don't want to parse words or have anybody leave here and be
confused, so you're not going to comment about Mr. Semanek and
Mr. Gruttadauria, but if, for the purposes of a hypothetical
there was a guy in Cleveland who was the branch manager and his
compliance officer was his subordinate, would you find that to
be an inappropriate supervisory structure?
Ms. Richards. In Cleveland or wherever--
Mr. LaTourette. Anywhere in the world.
Ms. Richards. Yes, we would be very critical of that.
Mr. LaTourette. Thank you.
Mr. Doherty. Could I add that in our view a producing
branch office manager needs to be supervised with respect to
his own production like any other salesman and so that I would
completely agree with Ms. Richards that supervision by a
subordinate, if that's the sole aspect of the supervision,
would not be, in our view, reasonable and we have brought
enforcement cases against firms and others where we felt that
was a deficiency.
Chairman Kelly. Ms. Richards, it's my understanding that
you put this oversight in place about 1998. Is that correct?
Ms. Richards. Oversight?
Chairman Kelly. The oversight of the decision being that it
was inappropriate for a branch manager or a broker to supervise
their own compliance officer. Wasn't that in place in 1998?
Ms. Richards. The duty to supervise has certainly been in
place and is the framework, the linchpin of the federal
securities laws--
Chairman Kelly. So it was not enough to stop Mr.
Gruttadauria, is that correct? Must have been. Is that correct?
Ms. Richards. Existing duties to supervise apparently
failed with respect to Mr. Gruttadauria.
Chairman Kelly. Thank you very much. Does either the SEC or
the New York Stock Exchange believe that they require greater
authority to detect fraud similar to Mr. Gruttadauria's? Is
there something here that we need to look at at the federal
level that will not impinge on the trading that's occurring,
will not impinge on the markets and yet do you need another
tool in your toolbox?
Ms. Richards. I would say that, on behalf of the
Commission, that we have 250 examiners for a population of
8,000 registered broker dealers, some 90,000 branch offices and
678,000 registered representatives that we police, with the
SROs, with 250 examiners. The Commission is now engaged in a
top-to-bottom review of its resources to determine whether or
not we need more--just simply need more people to do the job
that we need to do. Chairman Pitt has spearheaded that effort
and we're working closely with him to make those kinds of
determinations.
Chairman Kelly. What about you, Mr. Doherty?
Mr. Doherty. My reaction is I don't think we need
additional authority. I think we need to continue to gather
information and adapt our program. We have under consideration
some rules that would impose more specific requirements in this
area that would hopefully go a long way toward enhancing
investor protection in this area.
In the final analysis, however, responsibility has to be on
the member firms to put in place the kind of procedures that
the rules require and run their business in a way that's
compliant with the rules. We oversight that. The SEC oversights
that.
Overall, this system, has given us the best markets in the
world, but that doesn't mean that we can't improve things and
that's what we're trying to do.
Chairman Kelly. Well, I thank you all for your testimony. I
want to note that some Members may have additional questions.
I'm sure they do have additional questions for this panel and
they may wish to submit them in writing. So without objection,
the hearing record will remain open, as I had stated earlier,
for 30 days for Members to submit written questions to these
witnesses and to put their responses in the record.
I'd like to thank the first panel very much for appearing
here. We appreciate your testimony and I want to especially say
to you, Mr. Fazio, and Ms. Stout, you are excellent
spokespeople for those people who were damaged by Mr.
Gruttadauria's actions and we thank you for traveling so far to
be with us today.
With that, I'm going to excuse this first panel with our
great appreciation. Thank you so much.
Ms. Jones. Madame Chairwoman, just for the record, I found
that newspaper article that I was talking about with Lehman
Brothers with the reserves and not having enough money to help
out these folks and I would just like to submit it for the
record.
Chairman Kelly. With unanimous consent, so ordered.
Ms. Jones. Thank you.
Chairman Kelly. This panel is excused. I'd like to have the
second panel start taking their seats.
For our second panel we welcome Mark Kaplan, Managing
Director and General Counsel, SG Cowen Securities; Mr. Thomas
Hommel, Managing Director and Co-Head of Global Litigation for
Lehman Brothers; Daniel Sibears, did I pronounce that correct?
Mr. Sibears, did I pronounce that correctly?
Mr. Sibears. It's pronounced Sibears.
Chairman Kelly. Sibears, thank you very much. Mr. Sibears,
Senior Vice President and Deputy for Member Regulation for the
National Association of Securities Dealers; Mr. Bradley
Skolnik, Indiana Securities Commissioner and Chairman of the
Enforcement Section of the North American Securities
Administrators Association; and Marc Lackritz, President of the
Securities Industry Association. And we thank all of you for
being here. I appreciate your testimony before us today and I
welcome you on behalf of the full committee. Without objection,
your full written statements and any attachments that you have
will be made part of the record and you'll each now be
recognized for a 5-minute summary of your testimony.
I'd like to begin with you, Mr. Kaplan.
STATEMENT OF MARK E. KAPLAN, MANAGING DIRECTOR AND GENERAL
COUNSEL, SG COWEN SECURITIES
Mr. Kaplan. Thank you. Madame Chair, Members of the
Subcommittee, I thank you for the opportunity to come before
this Panel for this important hearing. On behalf of SG Cowen, I
pledge our company's full support for your efforts. We applaud
the Subcommittee for its leadership in working to protect
investors from fraud and other abuses.
SG Cowen is committed to doing everything possible to get
to the bottom of this scheme and to do what's right for our
former clients by making every effort to reach a fair and
equitable resolution of their claims.
I want to begin by briefly reviewing SG Cowen's short
involvement in the retail brokerage business and where Frank
Gruttadauria fit into that business. In July 1998, SG
Securities purchased most of the assets of Cowen & Company, a
wholly unrelated firm. Frank Gruttadauria had worked for Cowen
& Company for over eight years.
SG Securities did not have a retail brokerage business
until this acquisition. With the purchase, SG Cowen was formed
as a full-service investment banking and retail brokerage firm
in the United States.
In October 2000, a little over two years later, SG Cowen's
retail brokerage business, including Frank Gruttadauria and his
accounts, were sold to Lehman Brothers. Our firm has been out
of the retail brokerage business since that time.
Because we sold that business, we are faced with a unique
and significant challenge in piecing together what happened in
the Gruttadauria scheme. First, practically everyone involved
in SG Cowen's retail brokerage business no longer works at the
firm. As a result, we lack the institutional memory that would
help us resurrect and reconstruct what happened during the time
that Mr. Gruttadauria worked at the firm.
Second, the files that we are researching are stored on
vast amounts of paper and microfiche, not electronically. That
requires us to manually review more than 11,000 boxes of
documents relating to hundreds of thousands of transactions
and, to unravel this scheme, we must analyze every transaction
in every account.
Lastly, we are attempting to unravel a scheme that escaped
detection, notwithstanding the due diligence, compliance
procedures and independent reviews of several distinct
companies and outside entities--which points to the
sophistication and the complexity of this scheme. Even so,
speaking for SG Cowen, we wish our efforts had uncovered it
sooner and we're doing everything we can to ferret out what
really happened.
To do that, and from the very first day we learned of this
problem, SG Cowen has dedicated substantial company resources
to the complex task of reconstructing client records. This
includes well over 100 people working on a nearly around-the-
clock basis. We estimate that more than 30,000 person-hours
have been expended in this effort and we are far from finished.
While this is very much a work in progress, we have learned
some things that I would like to share with the panel. However,
and as I am sure you understand, we simply cannot comment on
matters that bear on the on-going investigations of the SEC and
the New York Stock Exchange and that are the subject of private
litigation.
What I can say is that some clients did receive false
statements with inflated account balances from Mr.
Gruttadauria. When they sought to withdraw funds, based on
these artificially high levels, Mr. Gruttadauria had to get the
money from somewhere else and that turned out to be the
accounts of other clients. That appeared to require him in turn
to provide false statements to those other clients and so the
scheme grew. Thus, at its root, this was a scheme in which
Frank Gruttadauria appears to have been robbing Peter to pay
Paul. Many questions still remain. Did some people lose
substantial sums? Did some people wind up with substantially
more money than their investments would have earned? Were the
compliance procedures and supervision at the various firms
inadequate? Or was Frank Gruttadauria's scheme unusually
sophisticated in evading detection?
Because of the nature of this scheme, we need to understand
what happened with all transactions and all affected accounts
before we can determine how to address any individual client's
claim. Again, we are pursuing this task with great urgency, but
it will take time.
Members of the Subcommittee, we offer our sincere apology
to the former clients of SG Cowen for the harm that Frank
Gruttadauria's conduct has caused them. His conduct is anathema
to us. That is not the way we do business and that is not who
we are. We are proud of our hard-earned reputation for
integrity in the marketplace and for what we do for our
clients. That is why SG Cowen will continue to work tirelessly
to determine exactly what happened and to make every effort to
reach a fair and equitable resolution of our former clients'
claims. We know that that can't happen fast enough for them and
they are absolutely right.
With that, I thank you very much for the opportunity and
welcome the chance to answer any questions you may have.
[The prepared statement of Mr. Mark Kaplan can be found on
page 96 in the appendix.]
Chairman Kelly. Thank you very much, Mr. Kaplan.
Mr. Hommel.
STATEMENT OF THOMAS E. HOMMEL MANAGING DIRECTOR AND CO-HEAD OF
GLOBAL LITIGATION, LEHMAN BROTHERS
Mr. Hommel. Thank you, Madame Chairwoman. My name is Thomas
Hommel. I'm a Managing Director with Lehman Brothers in New
York. I have a few remarks that I'd like to read into the
record, after which I'd be happy to answer any questions that
the Committee may have for me.
In January of this year, Frank Gruttadauria reportedly sent
a letter to the FBI admitting that he had defrauded his clients
for a period of 15 years. Mr. Gruttadauria worked for Lehman
Brothers for only 15 months at the very end of this 15-year
period. His employment resulted solely from Lehman's
acquisition of certain retail customer accounts and branch
offices from SG Cowen & Company in October of 2000. Prior to
Lehman's acquisition of the Cowen branches, we performed due
diligence with respect to Cowen's personnel and operations. Our
due diligence disclosed that Mr. Gruttadauria had a spotless
compliance record with not even a single customer complaint
against him, nor were there any significant number of customer
complaints in the entire Cleveland Office.
Lehman acquired over 60,000 accounts from Cowen, including
4,900 in the Cleveland Branch Office. Approximately 470 of
those accounts were handled by Frank Gruttadauria. It now
appears that Mr. Gruttadauria was indeed deceiving a relatively
small number of those clients, as well as his employers. He did
so by diverting account statements generated by the brokerage
firms for which he worked and preparing and sending to these
clients false statements reflecting nonexistent trades and
false account balances. These activities took place for a 15-
month period at Lehman Brothers for two basic reasons. First,
the addresses received by Lehman for 40 of Mr. Gruttadauria's
470 accounts were incorrect. These were the diverted
statements. Second, the assets delivered over to Lehman from
Cowen in those accounts were relatively small and the account
activity, both trading activity and transfers of funds, was
virtually nonexistent outside of a handful of accounts. Since a
brokerage firm is charged with safeguarding a client's
securities and funds, compliance systems are designed to do
just that and a lack of activity in these accounts at Lehman
meant that they were not singled out for scrutiny.
At the cornerstone of supervisory procedures for every
broker-dealer is the ability independently to send to all of
its customers confirmations and monthly statements reflecting
all activity in their accounts. In the tape to tape or computer
transfer of account information from Cowen to Lehman in October
of 2000, the incorrect addresses that Mr. Gruttadauria had put
in place at Cowen were transferred to Lehman. Thus, a
fundamental supervisory tool had been taken away from Lehman
without its knowledge as a result of purchasing accounts that
had defective addresses.
Moreover, nothing about the addresses that were on these
accounts appeared suspicious in any way. In virtually all
instances, the addresses appeared to be accounting firms or law
firms which presumably had been employed by the high net worth
client, or otherwise contained street addresses. Indeed, there
is nothing extraordinary about a high net worth client
directing his broker to send account statements to his
accountant or to a lawyer. One of the accounting firms listed
had a post office box included in the address, while another
was, in fact, an actual accounting firm with its actual street
address listed. Thirty of the 40 accounts transferred from
Cowen to Lehman that had incorrect addresses were directed to
one or the other of these accounting firms. The 40 accounts
that were transferred to Lehman that had bad addresses
contained assets of less than $5 millon. The false account
statements for those same accounts reflected equity of over
$250 million. From these hard facts, it is clear that to the
extent that the assets reflected in the false account
statements ever existed, they had been dissipated long before
they reached Lehman Brothers. Because there were relatively
modest amounts in the Lehman accounts, there was little or no
trading in these accounts. There were few transfers of funds as
well, again, putting aside a small handful of accounts.
On January 17, 2002, the very same day Lehman learned about
the alleged misappropriation, it sent a new management team to
Cleveland, as well as various other personnel to immediately
meet with clients. Lehman also immediately notified its
regulators and has fully cooperated with the numerous inquiries
it has received from those regulators and other governmental
entities. The complete former management team of the office was
replaced. All of Mr. Gruttadauria's clients were immediately
contacted to ensure that they knew precisely what was in their
accounts and meetings were conducted with the affected
customers to fully share with them what information the firm
had regarding their accounts. Indeed, within 3 weeks of Mr.
Gruttadauria's disappearance, Lehman Brothers had contacted
substantially all of Mr. Gruttadauria's 470 clients and we
personally have met with representatives, either family members
or counsel, of 24 of the families involved in Mr.
Gruttadauria's scheme, accounting for all but a few of the 60
accounts, which includes the fictitious accounts, for which
false statements were prepared.
Moreover, Lehman has already paid substantial sums to
certain customers, including the customers whose accounts
served as the bank for Mr. Gruttadauria's scheme at Lehman
Brothers, to reimburse them for funds misappropriated from
their accounts while at Lehman, without requiring those people
to sign releases. Lehman believes that the amounts already paid
represent a substantial portion of any funds that may have been
misappropriated while Mr. Gruttadauria was employed by Lehman,
and is continuing its efforts to identify and reimburse any
remaining customers for any such misappropriation that may have
occurred at Lehman. Lehman Brothers, unfortunately, was in the
unenviable position of having to tell these customers that they
were not worth what they thought they were. However,
substantially all of the alleged inflation in the account value
and substantially all of the alleged misappropriation took
place prior to these people ever become customers of Lehman
Brothers. Lehman Brothers, as part of its 150 year tradition,
places an enormous premium on earning the trust and confidence
of its clients. We regret deeply that these events took place,
but also firmly believe that our systems of supervisory
procedures are more than reasonably designed to prevent and/or
detect this type of activity.
Indeed, Lehman's compliance record since 1994, when the new
Lehman Brothers re-emerged, is an enviable one, with not a
single regulatory sanction associated with our private client
services business. We will continue to work with the affected
clients, with their counsel, with the regulators and the
Courts, to resolve the claims that have been raised in the most
fair and efficient manner possible.
Thank you.
[The prepared statement of Mr. Thomas E. Hommel can be
found on page 104 in the appendix.]
Chairman Kelly. We thank you.
We next go to Mr. Sibears.
STATEMENT OF DANIEL M. SIBEARS, SENIOR VICE PRESIDENT AND
DEPUTY FOR MEMBER REGULATION, NATIONAL ASSOCIATION OF
SECURITIES DEALERS
Mr. Sibears. Chairman Kelly, Members of the Committee,
thank you for the opportunity to testify on behalf of the NASD.
First, let me briefly describe the NASD. The National
Association of Securities Dealers is the world's largest self-
regulatory organization or SRO. Under federal law, the roughly
5500 brokerage firms and almost 700,000 registered
representatives in the U.S. securities industry, comes under
our jurisdiction. Employing industry expertise and resources,
we license industry participants, write rules to govern the
conduct of brokerage firms, educate our members on legal and
ethical standards, examine them for compliance with NASD and
federal rules, investigate infractions and discipline those who
fail to comply. We have a staff of 2,000 with headquarters in
Washington, D.C. and 15 district offices throughout the
country. We are governed by an independent Board of Governors,
at least half of whom are unaffiliated with the securities
industry.
I'm the Senior Vice President and Deputy for the Member
Regulation Department which has over 800 dedicated employees.
My testimony today will focus on the exam program which is the
largest function carried out by member regulation. I recognize
that the Committee has a significant interest in the
Gruttadauria case. For the reasons set forth in my written
statement, however, I am not in the position to comment
specifically on that matter which is under investigation by the
New York Stock Exchange and the Securities and Exchange
Commission.
On an annual basis, the NASD examines approximately 2600
brokerage firms' headquarters and over 200 branch offices. The
yearly schedule of exams is prepared in conjunction with other
SROs, including the New York Stock Exchange, pursuant to an
agreement to maximize cooperation and to minimize duplication
among regulators.
The exam process has advanced with technology. In the mid-
1990s, the NASD developed automated exam modules, essentially
taking the paper modules procedures and schedules of the past
and placing them on a computer. With the NASD's recent
development of INSITE which stands for Integrated National
Surveillance and Information Technology Enhancements, we use
sophisticated data mining techniques to detect signals of
change in member firm activities. This includes statistical
analysis of customer complaints, transactional and trading
information, registration information and financial
information.
All this technology is helpful in identifying problems, but
our goal is to have the systems that encourage firms to
identify and stop problems before they happen. We use all the
tools at our disposal, automated, manual and intellectual, to
anticipate problems. The tools used to conduct the exams have
changed and although the scope has grown, what we examine for
has not changed radically. During our on-site visits to the
firm's office, the examiners review the firm's books and
records such as financial computation work papers and
subsidiary ledgers, order tickets and confirmations, complaint
and correspondence file and many other records. Examiners check
that the firm's records support the regulatory filings that the
firm has made to the NASD in the case of trade reporting,
financial filings, complaint filings and advertising filings,
for instance. Examiners prepare independent financial
calculations to determine the financial condition of the firm,
including such measures as net capital and customer reserve.
Examiners also interview the firm's compliance officers and
management to learn about its supervision in operational
practices. The front line of our system of preventive
compliance is at the securities firm itself. All securities
firms are required to have supervisory systems and internal
controls. NASD takes our members' supervisory obligations very
seriously. Effective evolving supervisory systems form the
foundation of a firm's ability to ensure that its associated
persons are appropriately dealing with customers and the
customers are protected. Appropriate supervision safeguards the
firm and increases investor confidence, thereby ultimately
ensuring the fair and efficient functioning of our markets.
However, ordinary supervisory procedures may be
insufficient to ensure compliance in certain circumstances,
circumstances that may warrant heightened supervisory controls
include registered representatives who have been the subject of
numerous customer complaints, disciplinary actions or
arbitrations, registered representatives terminated from
association with prior firms for regulatory reasons or
concerns, registered representatives who have frequently
changed their employment and registered representatives whose
trading practices or customers appear on certain exception
reports generated by the firm to monitor customer accounts.
Firms that ignore such signals or red flags of sales
practice violations or that never put in heightened supervision
of problem brokers may themselves be the subjects of
disciplinary action for failure to supervise the brokers. While
today's hearing is focused on one bad actor, the overwhelming
majority of NASD members materially comply with the letter and
the spirit of the rules and the law. They view their own
reputation for fair dealing and high standards as a competitive
asset in a competitive industry.
The NASD's job is to protect investors by setting high
standards of conduct and by disciplining those that fail to
live up to those standards, sometimes by barring them from the
industry for life.
I'd be pleased to take any questions that you may have.
[The prepared statement of Mr. Daniel Sibears can be found
on page 109 in the appendix.]
Chairman Kelly. Next we go to Mr. Skolnik.
STATEMENT OF BRADLEY W. SKOLNIK, INDIANA SECURITIES
COMMISSIONER AND CHAIRMAN, ENFORCEMENT SECTION, NORTH AMERICAN
SECURITIES ADMINISTRATORS ASSOCIATION
Mr. Skolnik. Chairwoman Kelly and Members of the
Subcommittee, I'm Brad Skolnik, Indiana Securities Commissioner
and Chairman of the Enforcement Section of the North American
Securities Administrators' Association. I commend you for
holding this hearing and thank you for the opportunity to
appear today.
The Securities Administrator in your state is responsible
for the licensing of investment professionals and securities
offerings, investor education and most importantly the
enforcement of state securities laws. We've been called the
local cops on the beat and I believe that is an accurate
characterization.
Today, our focus is on the case of Frank Gruttadauria. My
testimony will focus on two questions. What should be done to
prevent another Gruttadauria from cheating investors out of
their money and what steps can investors take to better protect
themselves from these criminals?
I believe our securities laws and regulations are
fundamentally sound. One lesson from this case might be that
compliance departments need to toughen their enforcement of the
rules already on the books. Compliance departments must have
reasonably designed standards and systems in place to prevent
and detect fraud. For example, it's important that firms
implement an effective, centralized compliance system to
approve the opening of accounts and to monitor associated name
and address changes.
In addition, I encourage brokerage firms of a reasonable
size to provide on-line access to their customers' account
statements. Investors will then be able to check their mailed
account statements against the information provided directly by
the firm's website which is not subject to manipulation by a
crooked broker.
Another useful tool would be more resources for regulators.
I applaud recent House action to raise the SEC budget. We need
to make sure that both state and federal regulators have the
resources they need to do their jobs. There's also another way
to fight these criminal fraudsters. Securities regulators must
work with prosecutors to obtain more criminal convictions. The
prospect of serious jail time is the only way to deter these
calculating cold-blooded recidivist criminals. Anything less is
viewed as just the cost of doing business.
Think about it. Someone steals your car, they go to prison.
A con artist steals the money your parents saved for retirement
and all too often, only gets fined. That's just not right.
Make no mistake about it. Frank Gruttadauria stands accused
of being an unscrupulous scam artist and his alleged criminal
activities will be addressed in a court of law. However, as a
State Securities Commissioner, I've encountered too many
fraudsters who have swindled hard-working Americans out of
their life savings.
Indeed, over the past few years, in my home state of
Indiana, we've encountered at least two high profile incidents
where stock brokers employed some of the same tactics such as
the issuance of fictitious account statements to plunder their
clients.
The question is how can we better protect investors from
being victimized by the next Gruttadauria? We need to realize
that no matter what we do, there will be always be diabolical
con artists. That's why stiff penalties and long prison
sentences are so important.
In addition, NASAA has some tips for how investors might
better protect themselves from these sophisticated scams.
First, periodically check mailed account statements against on-
line information from the firm's website or by calling the
firm's headquarters. Secondly, we've all heard the saying,
don't put all your eggs in one basket. Investors should
consider spreading their investments possibly among two or
three firms. Third, contact your State Securities Regulator to
check out a broker before doing business with them. We can tell
you if the company or individuals offering investment advice
are licensed or if they have any disciplinary history. Fourth,
use common sense. If written account statements show you're
making lots of money at a time when the stock market is in
decline, maybe you should double check your accounts with the
firm's compliance office. Fifth, with the advent of desktop
publishing and technology, it's not difficult to create bogus
account statements. I encourage investors to carefully check
for typographical errors that sometimes appear on falsified
statements. Sixth, many investment professionals use either
custodians or clearing brokers to hold their clients' funds and
securities. Investors should periodically compare statements
received from their broker with these independent third parties
for confirmation and accuracy. And finally, investors should
make sure their account statements are issued by the brokerage
firm or mutual fund complex and not from some other assumed
business name used by the investment professional.
I applaud you for holding these hearings in an effort to
shed light on the criminal abuses in the securities markets.
The problems in this area are serious, but can be successfully
addressed if securities regulators and policy makers work
together on solutions and if investors are properly educated so
they can protect themselves. Thank you very much.
[The prepared statement of Mr. Bradley Skolnik can be found
on page 116 in the appendix.]
Chairman Kelly. Thank you very much, Mr. Skolnik. I hope
that anyone who receives a transcript or has any indication of
what you've just said who is an investor will listen and act
upon those seven suggestions. Thank you for putting them into
the record.
We go now to Mr. Lackritz.
STATEMENT OF MARC E. LACKRITZ, PRESIDENT, SECURITIES INDUSTRY
ASSOCIATION
Mr. Lackritz. Thank you, Madame Chairwoman, and Members of
the Subcommittee. Thank you very much for the opportunity to
testify today to describe the regulatory structure of the
securities industry which I know you've already heard a little
bit about, the efforts that we're making to continually improve
compliance and prevent fraud, and a new investor education and
information efforts underway to help empower investors and
prevent this kind of incident.
The securities industry is profoundly concerned whenever an
investor loses money through fraud and we share your
Subcommittee's outrage over this particular incident. Indeed,
we're embarrassed that this type of fraud has even occurred
because although it happens only rarely, it simply should not
occur at all. Our industry prides itself on our dedication to
ensuring the highest ethical standards among our professionals
and our deep commitment to earn the public's trust and
confidence that the markets operate fairly with complete
integrity. When that trust and confidence are undermined in any
way, our reputations are diminished and investors become more
reluctant to provide the capital that companies need to grow
and flourish, employ more workers and provide financial returns
that boost our nation's prosperity. That's why we have no
tolerance for those who have broken the law and we believe that
bad actors should be prosecuted to the full extent of the law.
Although this, episode of fraud is egregious and
unacceptable, it is important to note how rare these incidents
are. More than 99.99 percent of all transactions result in no
complaints, a record that other industries and professions
envy. Since 1995 the increases in dollar volume in securities
transactions dwarf the increase in complaints. Every single day
nearly $700 billion in transactions clear and settle on the
stock and debt markets based on a handshake, a nod, a hand
signal, a keystroke or a phone call. This would not be possible
without strong, fair regulatory scheme that protects investors
and ensures the integrity of the markets.
The securities industry multi-tiered regulatory structure
makes them amongst the most highly regulated industries. The
first layer of investor protection occurs within the brokerage
firm itself. Broker dealers are responsible for complying with
every law and regulation pertaining to their business,
including the strict supervision of all personnel. They must
also comply with mandatory continuing education programs.
SROs, the second tier of regulation, verify that brokerage
firms have systems and procedures in place to manage themselves
properly and to comply with securities regulations, review
firm's books and records, and administer tests and supervise
the industry's mandatory continuing education requirements.
They also create a compliance system by which individuals and
securities firms can police their own activities. For example,
the NASD regulation maintains a public disclosure program on
its website. I've give you that address in my written
testimony, as well as a toll-free telephone number that
provides disciplinary information on all licensed securities
brokers. This resource which we believe is unique in any
profession, enables investors to know instantly whether a
broker with whom they are considering doing business has ever
had disciplinary action taken against him or her.
As you know the SEC is charged with preserving the
integrity, efficiency and fairness of the securities markets by
administering and enforcing the federal securities laws. And it
also oversees the SROs. They have a long and successful history
of detecting fraud and punishing wrongdoers. This year already,
the SEC brought more enforcement actions in the first quarter,
61 cases, than it did during the same period last year and in
taking the helm of the SEC, Chairman Harvey Pitt is refocusing
the agency's role on catching problems early rather than
spending years developing a case and then imposing penalties.
We support this effort and Chairman Pitt's request for more
resources to expand the commission's legal and enforcement
staff and we appreciate this Subcommittee's and Committee's
full support of greater resources for the SEC because a fully-
funded SEC is critical for both the securities industry and our
customers.
As you know, Congress is the ultimate overseer and ensures
that the SEC is fulfilling its responsibility to regulate the
markets.
This regulatory structure has been extremely successful by
fostering the broadest, deepest, most transparent markets in
the world and now countries across the globe are trying to
emulate our system. I think we've established a record the
entire industry can be proud of, the public can rely on and
other industries can only envy. Yet, once in a while a bad
actor slips through the structure and defrauds our customers.
When this happens, the industry works very, very hard to make
customers whole and to improve our system by detecting and
stopping fraud. Broker-dealers use sophisticated technology to
detect abuses. For example, computers compare clients'
electronically-stored profile against the trades he or she is
trying to undertake. If the two don't match, the broker-
dealers' compliance officers will scrutinize the activity
immediately. Market regulators also use advanced state-of-the-
art software and computerized surveillance systems to detect
and investigator signs of foul play.
In addition to our efforts to stop fraud before it happens,
the broker-dealers in the industry are redoubling our investor
education efforts so that investors will have the necessary
tools and skills to invest responsibly and avoid being
defrauded. We have published literally dozens of educational
brochures and participated in investor town meetings across the
country organized by the SEC. In addition, we fully support the
Treasury Department's new campaign for financial literacy, a
goal our industry has been committed to achieving for more than
25 years through our stock market gain. More than 600,000
students in fourth through twelfth grade participate in this
10-week program that combines basic economic education with an
investment simulation exercise.
We also recently launched a new website,
www.siainvestor.org which provides interactive on-line learning
tools that addresses investors' different needs and it's free
to anyone that accesses it.
The securities industry works in concernt with government,
regulators and self-regulatory organizations to promote a
culture of trust and confidence which are our most important
assets. In such an environment, innovation soars, competition
thrives and investor confidence flourishes. We will continue to
work together to eliminate any and all incidents of wrong-doing
through effective leadership, compliance, self-regulation and
more investor education. These actions will help maintain and
enhance the public's trust and confidence which is good for
investors, good for our industry and good for our country.
Thank you very much.
[The prepared statement of Mr. Marc Lackritz can be found
on page 122 in the appendix.]
Chairman Kelly. We thank you. I'd like to open the
questioning with a question to Mr. Kaplan and Mr. Hommel. Have
you contacted Mr. Fazio and Ms. Stout with regard to their
accounts because they said here, today that you have not?
Mr. Kaplan. I can begin. I did hear their testimony. I have
not personally spoken to them. I have personally spoken to many
of Mr. Gruttadauria's clients. The only thing that I can say,
Chairperson Kelly, is that we are committed to reaching a
resolution, a fair resolution with each of these clients. It is
very difficult, we understand, for these clients to have gone
through this. We are committed to that process. We understand
that it has been a long one, but this is one that we are
committed to and one we have devoted a tremendous amount of
resources to.
Chairman Kelly. Mr. Kaplan, if I understand the testimony
here this morning, Mr. Gruttadauria had less than 500 clients,
is that correct?
Mr. Kaplan. I believe that may be generally accurate,
correct.
Chairman Kelly. And Mr. Kaplan, all of this happened, the
problem became apparent as I understand it, in January. How
long do these people have to wait before they get some kind of
contact from your company?
Mr. Kaplan. I agree with the Chairperson that this process
has not moved as quickly as we would like and I know the
clients would like. As I indicated in our oral statement, the
process for us of unraveling this scheme has been a very
complex one and one that has required a lot of time and a lot
of resources.
As I indicated, this for us, has not just meant reviewing
the two years that he worked at SG Cowen, but we have gone back
to look at all of the records while he worked at Cowen and
Company and this has required us to piece together each of the
individual transactions in each of the accounts which, because
of the way records were kept, has required a manual review of
all of those records. We have devoted at this time about $4 to
$5 million to try to recreate these accounts. This has meant
scores of lawyers, scores of accountants. We recognize the
urgency. We appreciate your efforts and you have our pledge
that we will work as quickly as possible to try and reach a
fair and equitable resolution with those clients.
Chairman Kelly. Mr. Hommel, you have not answered these
questions. Will you, please?
Mr. Hommel. Madame Chairwoman, within 30 days after Mr.
Gruttadauria's disappearance, I personally met with Ms. Stout
in her home in Elgin, Illinois, as well as with Mr. Fazio and
his counsel, Mr. Kranz, in Mr. Kranz' office in Cleveland. We
also met with representatives or the clients of 24 of the other
families who were involved in Mr. Gruttadauria's scam. The
purpose of the meeting was to make sure that these folks had
the information that we had so that we were all dealing with
the same set of facts, and in fact, many of the folks did not
have their actual account statements. We brought them with us
and gave them to them. We asked them to show us the false
account statements that they were receiving so that we knew
what they were receiving and from that point forward, we've
engaged them, in some instances with greater success than in
others, in discussions that are designed to ultimately lead to
a resolution of this situation.
Chairman Kelly. Mr. Kaplan, you're aware, I know, of the
New York Stock Exchange 1998 enforcement action against Cowen.
Can you discuss with us the changes, if any, that the firm made
to address the failure to reasonably supervise branch office
managers acting in the capacity of registered representatives,
that that terminology was in that report. Can you address that?
Mr. Kaplan. Yes. Shortly before SG Securities acquired
Cowen and Company, Cowen and Company did enter into a consent
order with the New York Stock Exchange that related to a number
of different issues. As a result of that consent order, SG
Cowen implemented a number of changes. It hired a number of
additional personnel in the compliance department, including a
new director of branch examination whose role was to go out and
conduct audits of each of the branches. There was a compliance
committee formed at the very top of the company to review both
the progress with this order and to review generally the
compliance procedures. There were personnel changes in the
margin department and there were supervisory changes within the
firm. I do know from looking back at this material that six
months later, an outside independent law firm came and reviewed
the changes that were made. That law firm certified to the
Exchange and certified to the executives at SG Cowen that
changes, in fact, were made. The issue that you raise is an
important one, which is whether those changes could have
prevented this fraud from happening. That is an issue that we
are looking at as well. That is an issue that we are
cooperating on with the New York Stock Exchange.
Chairman Kelly. Thank you. I'm out of time and I'm going to
go now to Ms. Jones.
Ms. Jones. Thank you, Chairwoman Kelly. Let me say at the
outset to all the panelists I have 5 minutes. I'm going to ask
short questions. I'd like short answers, if you could
facilitate me, please.
Mr. Kaplan, during the period of time that Mr. Gruttadauria
was employed with SG Cowen, how much money did you make from
his trades?
Mr. Kaplan. I am not sure.
Ms. Jones. Could you get an answer for me, sir?
Mr. Kaplan. Yes, I will.
Ms. Jones. It was more than $2 million, $3 million, $4 or
$5 million that you could say that, could you not, sir?
Mr. Kaplan. I can't speculate, but I will provide you with
that exact information.
Ms. Jones. How much money did SG Cowen make in 1995?
Mr. Kaplan. We did not acquire Cowen and Company and Mr.
Gruttadauria until 1998.
Ms. Jones. How much did you make in 1998?
Mr. Kaplan. Again, I apologize that I do not have those
specific figures.
Ms. Jones. You understand why I'm asking these questions,
do you not, Mr. Cowen
Mr. Kaplan. You are right to focus on those issues. I
apologize that I don't have the answers for you right now.
Ms. Jones. In fact, the people who lost dollars as a result
of his conduct--strike that. You do understand that you are
responsible for the conduct of Mr. Gruttadauria, do you not,
sir?
Mr. Kaplan. We understand our responsibility here.
Ms. Jones. That wasn't my question. My question is that you
do understand that you are responsible for the conduct of
Gruttadauria?
Mr. Kaplan. We do understand that and, as I indicated, we
are committed to reaching a fair and equitable resolution with
his clients.
Ms. Jones. There may be a little question as to what is
fair and equitable in light of the fact that Mr. Gruttadauria
represented to these people and they relied upon his
representation that they have a certain amount of money when
you may now come and say well, the real thing you have was X,
but I have a piece of paper that said I had 10 times that?
Mr. Kaplan. Well, I think that is one of the issues that
will go into the decision or the discussion as to what is a
fair and equitable resolution. There are clients--
Ms. Jones. Thank you very much. I hate to cut you off. Let
me go on now to Mr. Hommel. Pronounce it for me, sir?
Mr. Hommel. Hommel.
Ms. Jones. Hommel. How much did you make even though you
only had Mr. Gruttadauria, at least that's your statement work
for you for only 18 months, how much money did you make from
his trading?
Mr. Hommel. I also do not have precise figures for you, but
I would note that the trading activity during Mr.
Gruttadauria's tenure at Lehman Brothers was very, very low.
Ms. Jones. That wasn't the question I asked you.
Mr. Hommel. I don't know, ma'am.
Ms. Jones. You can get that information for me, can you
not, sir?
Mr. Hommel. I will.
[The following information was subsequently furnished by
Mr. Thomas E. Hommel for the hearing record.]
[During the period of time Mr. Gruttadauria was
employed by Lehman Brothers Inc. the gross revenue
generated by transactions in the accounts serviced by
him was $3,122,515. Mr. Gruttadauria's total
compensation for salary and sales credit for that same
time frame was approximately $1,007,000.]
Ms. Jones. Can you tell me who Mr. Steve Lessing is?
Mr. Hommel. Mr. lessing is the head of sales for our
organization.
[From 1996 through April 2000, Stephen M. Lessing was
Head of Global Sales and Research of Lehman Brothers
Inc., responsible for the Firms's Fixed Income and
Equity Sales and Research organizations, as well as the
Private Client Services business. In April 2000, Mr.
Lessing became the Senior client Relationship Manager
for the Firm and Head of the Private Client Services
Group.]
[The following information was subsequently furnished by
Mr. Thomas E. Hommel for the hearing record.]
Ms. Jones. How long has he worked for Lehman Brothers?
Mr. Hommel. Mr. Lessing has been there for at least as long
as I have which is 16 years, but I don't quite know the exact--
[Mr. Lessing has worked for Lehman Brothers for 22
years.]
Ms. Jones. Okay, and what was his supervisory authority,
sir?
Mr. Hommel. He is basically the global head of sales.
[As head of Private Client Services, Mr. Lessing had
general executive responsibility for the operation of
that business, but was not the day-to-day business
head.]
Ms. Jones. Then he had oversight over Mr. Gruttadauria?
Mr. Hommel. That would include institutional sales, retail
sales, sales in many different forms.
[From October 2000 to January 22, 2002, Mr.
Gruttadauria was employed in the Private Client
Services business of Lehman Brothers.]
Ms. Jones. The answer is yes or no, sir.
Mr. Hommel. Yes ma'am.
Ms. Jones. Okay, thank you. And what was he paid, sir?
Mr. Hommel. I don't know, ma'am.
Ms. Jones. Can you get that information for me?
Mr. Hommel. I will do so.
[For the fiscal year 2001, Mr. Lessing was paid a
salary of $450,000 and received a cash bonus of
$2,050,000. He also received $2.5 million worth of
restricted stock units which will vest over a period of
five years in accordance with the terms of the plan
pursuant to which they were issued. Mr. Lessing also
received options for the purchase of 300,000 shares of
Lehman Brothers Holdings Inc. stock.]
Ms. Jones. And you can also get for me the information as
to how much money you made as a result of the sales by Mr.
Gruttadauria.
Mr. Hommel. We will do that.
Ms. Jones. Let me go on a little bit. There's an article
dated April 27th that says the SEC accuses Mr. Gruttadauria of
stealing client money for himself and using some of it to
shower Ms. English with $600,000 in cash and $100,000 worth of
gifts. Let me take you to the NASD standards for discipline and
somewhere it's either there or one of your other people who
testified said that is a signal for a broker to not be giving
gifts to other employees in the firm. I'm not quite saying it
correctly, but you understand what I'm saying to you, don't
you, sir?
Mr. Hommel. Yes, we have a policy which prohibits managers
from making such gifts.
Ms. Jones. In fact, could you find out for me how much
money was showered upon Ms. English as a result of the conduct
of Mr. Gruttadauria and if, in fact, it was in violation of
your standards, what you did about it?
Mr. Hommel. We will endeavor to do that. Of course, we may
not have all the information necessary to get a complete
picture. Ms. English would be in a better position to do that.
[We are not in possession of any records or information
regarding the value or extent of any gifts allegedly
given by Frank Gruttadauria to Laurie English. Lehman
Brothers was unaware of any such gifts.]
Ms. Jones. Let me ask you. What is a Lehman Brothers policy
with regard to a broker, a branch office manager supervising a
compliance officer and then who supervises a branch office
manager? All right, who didn't want me to talk? It's okay. I'm
going to go anyway. Who supervises the branch office manager in
his investment and trading?
Mr. Hommel. In this instance, Mr. Gruttadauria had a direct
reporting line into the regional management office in Chicago,
so he was supervised directly by the regional manager in
Chicago and the regional office in Chicago.
Ms. Jones. And who was that person?
Mr. Hommel. The regional manager in Chicago's name is
Michael Smith.
Ms. Jones. Was he the regional manager at the time that Mr.
Gruttadauria was employed by your company?
Mr. Hommel. He was.
Ms. Jones. How much money did he make as a result of the
trading of Mr. Gruttadauria?
Mr. Hommel. I do not know.
Ms. Jones. You can get that information for me as well?
Mr. Hommel. I'd be happy to get that for you.
Ms. Jones. Thank you very much.
[There was no direct relationship between revenues
generated by Frank Gruttadauria and Michael Smith's
compensation.]
Chairman Kelly. You're out of time.
Ms. Jones. I'll come back.
Chairman Kelly. Would you like to have those articles that
you held entered into the record?
Ms. Jones. Yes ma'am, thank you very much.
Chairman Kelly. With unanimous consent, so moved. Mr.
Tiberi.
Mr. Tiberi. Thank you, Madame Chair. To Mr. Kaplan and Mr.
Hommel, did Lehman and Cowen have a policy requiring disclosure
of a special fiduciary relationship and I'm speaking to the
issue of Mrs. Cuneo who passed away in 1997 and the fact that
Mr. Gruttadauria was named executor of her estate.
Mr. Kaplan. On behalf of SG Cowen, I am not sure what the
firm's policy was at that time as to individual brokers acting
as trustees for client accounts.
Mr. Tiberi. Can you get us that information?
Mr. Kaplan. I can.
Mr. Tiberi. And can you get us that information of what--
well, it wouldn't apply to you. Mr. Hommel?
Mr. Hommel. Yes. I can tell you that if a firm employee
were to accept responsibilities in that capacity, it would have
to be disclosed. I will let you know whether or not there was a
prohibition on that, but I can tell you that if there were an
acceptance of those responsibilities it would have to be
disclosed to the compliance department of the firm.
[S.G. Cowen approved of Mr. Gruttadauria acting as the
broker for the Estate of Anne Cuneo with respect to
which he acted as the Executor. Since that account was
acquired by Lehman, the relationship remained in place.
At Lehman, the decision whether to allow a broker to
service an account where he or she may be acting in a
fiduciary capacity is made on a case-by-case basis.]
Mr. Tiberi. Do you know, to your knowledge, did anyone
check those disclosures in Mr. Gruttadauria's case?
Mr. Hommel. I don't know.
[There is no record of any inquiry with respect to Mr.
Gruttadauria acting as Executor of the Estate of Anne
Cuneo.]
Mr. Tiberi. You can find out?
Mr. Hommel. We will find out for you.
Mr. Tiberi. Thank you. Continuing, Mr. Hommel, are the
press reports accurate that your firm gave Mr. Gruttadauria a
$5 million bonus to remain in the Cleveland office and run it?
Mr. Hommel. We paid Mr. Gruttadauria a $5 million retention
bonus as part of that acquisition, as we paid a retention bonus
to the other brokers of Cowen who came over to Lehman Brothers.
We believe that that is commonplace in these types of
transactions. I personally don't know of any transaction
involving the sale and purchase of retail assets that did not
involve retention bonuses for the simple reason that ours is a
very fluid industry from the employment perspective. Brokers
are free to go to whomever they'd like to work with.
Mr. Tiberi. Thank you. With that purchase, did you also
accept their liabilities and their assets?
Mr. Hommel. I'm sorry?
Mr. Tiberi. With that purchase, did you accept their
liabilities and their assets?
Mr. Hommel. No, we didn't. We purchased accounts and the
asset purchase agreement is very clear that we did not accept
liabilities.
Mr. Tiberi. During the purchase, were you aware of the 1998
fine against that office from the New York Stock Exchange?
Mr. Hommel. Yes, we were.
Mr. Tiberi. You were. And Mr. Kaplan, just to follow up on
Ms. Kelly's question earlier, you said you had met with victims
or met with some of the victims. What efforts have been made by
Cowen to fully make the victims whole?
Mr. Kaplan. At this point our efforts have been focused on
trying to understand what happened in each individual client's
accounts. As I indicated in my oral testimony, this scheme was
perpetrated by shifting monies from one account to another
account. In order to understand what is a fair and equitable
resolution with each client, we must understand how much a
client put in and how much a client took out. That process has
involved a tremendous amount of work and when we complete that
process, we will meet with each of the clients to reach that
resolution.
Mr. Tiberi. What's the time line, Mr. Kaplan, do you have
any idea?
Mr. Kaplan. I hope to complete that process within the next
several months.
Mr. Tiberi. I yield the balance of my time to Mr.
LaTourette.
Mr. LaTourette. Thank you very much, Mr. Tiberi. Mr.
Kaplan, on October 15 of 1997, the New York Stock Exchange sat
down with counsel for Cowen, I believe they're Wilke, Farr and
Gallagher, and during the course of that and that had to do
with the allegation of violation of New York Stock Exchange
Rule 342, failure to supervise in accordance with those
procedures. And then in the response document, do you have your
response document from that time with you?
Mr. Kaplan. I do not have it, sir, although I have some
familiarity with it.
Mr. LaTourette. Okay, and Madam Chairwoman, I'd ask
unanimous consent that this response document be made part of
the record and I'd ask that the document be supplied to Mr.
Kaplan so that he can refer to it. But the salient points are
that Cowen promised a sea of changes relative to the
investigation by the New York Stock Exchange and in pertinent
part on page 76 indicates Cowen recognizes the concern that
arises from a situation in which the operations manager is
placed in a position of supervising to even a limited extent
the individual to whom he or she reports. Does that comport
with your response to the New York Stock Exchange's inquiry?
Mr. Kaplan. Well, again, SG Cowen or SG Securities, when it
purchased Cowen and Company in 1998, was made aware of this
consent order and, as I indicated, implemented a number of
changes in conjunction with the Exchange. In order to address
these very problems raised by the Exchange, it is clear that
that is one of the issues that we are looking into as to
whether those changes could have caught someone like Mr.
Gruttadauria who perpetrated this scheme.
Mr. LaTourette. When Mr. Doherty met with me the other day,
he indicated that the $385,000 fine levied by the New York
Stock Exchange, only 12 fines have been larger in the history
of the Exchange. I don't ask you to comment on that, but the
question is if the statements in that pleading were true, when
SG Cowen acquired the business in 1998, it's my understanding,
even though you couldn't answer Ms. Tubbs-Jones' question that
Mr. Gruttadauria generated for SG Cowen $5 million in 1998 and
$5 million in 1999 as commission. Now I'll ask you to go back
and check that out. And my question is, if that's true, and I'm
going to ask you to assume that that's true, how, by examining
the accounts that you took possession of in 1998, could there
ever be a justification for fees or commissions of $5 million
produced by this man? The amount of equity in the accounts
versus what the commissions were, if you accept my statement
that he earned $5 million for your firm, they don't match and
why didn't that do something to you guys? Why didn't that raise
a red flag? Why didn't that come to anybody's attention?
Mr. Kaplan. Mr. Gruttadauria, as we have heard all of this
morning, put together a very complex and sophisticated scheme.
You heard how he gained the trust of his clients. He betrayed
the trust of these clients. One of the things that we're
looking into is whether this was a matter of someone who put
together a very complex and sophisticated scheme that evaded
detection by all of the firms he worked for, firms that
conducted due diligence, and by their compliance departments
and their supervisors. That is one of the issues that we know
we are obligated to address to this panel, his former clients
and to the Exchange. That is a very important issue. I cannot
at this point indicate how that took place.
Mr. LaTourette. Madam Chairwoman, I see Mr. Tiberi's time
has expired. If I might continue on my own time?
Chairman Kelly. By all means, proceed.
Mr. LaTourette. Thank you very much. Mr. Hommel, that
raises a question of you and I'll ask you to assume for the
purposes of my question that, in fact, Mr. Gruttadauria did
earn commissions for SG Cowen of $5 million in 1998 and 1999,
but regardless of what the number is, during the course of the
due diligence conducted by Lehman, you would be aware of what
his potential was or what he had generated for Cowen or no?
Mr. Hommel. We would know what his production statistics
were, yes.
Mr. LaTourette. For 1998 and 1999?
Mr. Hommel. Yes.
Mr. LaTourette. If I'm correct that for both years it was
$5 million or there abouts and if you are correct that most of
the thefts that occurred prior to the transfer of these
accounts from SG Cowen to Lehman Brothers, does that not raise
some question in your mind how accounts that you say have a
diminished value, by the time you receive them, have produced
$5 million in commissions for SG Cowen in the two previous
years?
Mr. Hommel. Certainly in retrospect, as we look at it now.
As we looked at it then, looking at the New York Stock Exchange
investigation and the results of it and Mr. Gruttadauria's
statistics, there was nothing to indicate to us at that point
that whatever commission level Mr. Gruttadauria earned in 1998
and 1999, was through the use of anything but trading on a
legitimate basis with his accounts.
Mr. LaTourette. And Mr. Kaplan, back to you. We've heard
talk about the 1993 anonymous complaint filed with the
Securities and Exchange Commission and how that was resolved.
Were you aware of that, sir?
Mr. Kaplan. No. As I indicated, SG Securities did not
acquire the firm until five years later. We first learned of
this anonymous complaint as it hit the press yesterday. We have
checked our records and we have seen no evidence of that in any
of the due diligence or in his files.
Mr. LaTourette. And Mr. Hommel, the same question to you.
Before it was reported in the press, yesterday, did you have
any indication of this 1993 complaint?
Mr. Hommel. No, none whatsoever.
Mr. LaTourette. Mr. Kaplan talked about perhaps this was a
fellow who was engaged in a rather elaborate scheme, sort of
indicating a uniqueness to it, but what Mr. Gruttadauria was up
to was not unique at all. This has happened before, has it not,
this same pattern of behavior, Mr. Hommel?
Mr. Hommel. I don't see this as a pattern of behavior that
we have experienced before.
Mr. LaTourette. You do not see it?
Mr. Hommel. No, if you're referring to--
Mr. LaTourette. Let me get to that. I think that Mr. Daouk
and when you were in my office, you indicated that Mr. Daouk is
different because he was a referring broker, as opposed to
someone who is an employee and I guess that I became surprised
then when I read the District Court decision from 1998 that
indicated that Lehman effectively made WIS, Mr. Daouk's company
its de facto branch office. And as I understand the facts in
the Daouk case which is currently--is it resolved yet?
Mr. Hommel. No, it's still pending.
Mr. LaTourette. Then it was pending at the time that you
were doing your due diligence in an attempt to purchase SG
Cowen's retail business, was it not?
Mr. Hommel. It was.
Mr. LaTourette. It's my understanding that in the Daouk
matter, Mr. Daouk had created new signatures for clients to
allow them to authorize future transactions, that he had
prepared and distributed forged monthly account statements,
that he had used a personal off-network computer and that he
had established post office boxes where he intercepted the
client information sent from Lehman and that he churned
accounts in order to generate excess commissions which were
shared by both he and Lehman Brothers.
Is it your observation that that pattern of conduct that
Mr. Daouk is accused of engaging in is significantly different
from Mr. Gruttadauria's behavior?
Mr. Hommel. I do.
Mr. LaTourette. And can you explain to me why you think
that is so?
Mr. Hommel. I think that because first, Mr. Daouk was never
an employee of Lehman Brothers. He was never an employee of
Shearson Lehman Brothers. He was an employee of E.F. Hutton
back in the mid-1980s in its Beirut office. E.F. Hutton closed
its Beirut office in 1986 and the office was taken over by a
firm called World Investor Services which never had any direct
affiliation with Shearson Lehman Brothers or Lehman Brothers. I
think the passage you're referring to is the court's recitation
of an allegation in the complaint.
However, the fact is that World Investor Services entered
into an introducing broker relationship with E.F. Hutton to
which Shearson Lehman Brothers succeeded when Shearson bought
Hutton in late 1987 or early 1988. That contractual
relationship persisted through 1992 when the business left us.
Mr. Daouk worked for an introducing broker that referred
accounts to E.F. Hutton and later to Shearson Lehman Brothers.
They were the primary point of contact with those clients. The
clients were predominantly Lebanese nationals with some Saudi
nationals. The accounts were largely opened in the mid-1980s
when there was a civil war in Lebanon. Mail service was
sporadic, if existent at all, and post office boxes to my
understanding, were in wide use. In any event, we never had
direct contact with these clients. Mr. Daouk, as the referring
broker, did. He also took discretion on the accounts so that
Shearson Lehman Brothers and Hutton before them, essentially
acted as a clearing broker for these trades.
Mr. LaTourette. The two accountant firms, accountancy firms
that Mr. Gruttadauria established, I'll find my notes, but
basically where these statements were going, WJS and DH--
Mr. Hommel. One is an actual accounting firm.
Mr. LaTourette. Which one is an actual accounting firm?
Mr. Hommel. I believe it's DeGrandis and DeGrandis.
Mr. LaTourette. Okay. And then how many of the fraudulent
statements were going to--the real statements were going to
that accounting firm.
Mr. Hommel. There's a universe of 40 accounts that were
transferred over. There were 60 accounts for which false
accounts were created, but a number of them had--they were
fictitious in their entirety, that is, there was no
corresponding Lehman Brothers account. For the 40 accounts that
came over from Cowen for which fictitious account statements
were created, but for which real accounts did exist, 30 of
those account statements were diverted to one or the other of
the accounting firms. Seventeen, I believe, went to JYM
Accounting. JYM had a post office box. Those 17 were--17 of the
18 of the accounts that had post office boxes. The other one
happened to be a legitimate account so that the customer was
actually getting the fake statement and the real statement with
the same number at the same address. However, 30 of the 40 went
to the accounting firms. Seventeen of them went to the post
office boxes in the name of JYM.
Mr. LaTourette. Were you in the room when the first panel
testified?
Mr. Hommel. I was.
Mr. LaTourette. You had the opportunity to listen to those
folks. The exhibits that we put up relative to the activity,
just based upon your experience and how you guys run your
firms, the activity of Mr. Fazio's account in 1990 that we had
on the chart, is there anything that in your experience would
have triggered perhaps an inquiry by members of your firm had
you been aware of it?
Mr. Hommel. I think that those numbers may have triggered
some type of response from compliance supervisory systems, but
to say out of context right now what our reaction would have
been back then had it been us instead of some other firm, I
don't think that I can speak to that.
Mr. LaTourette. How about you, Mr. Kaplan?
Mr. Kaplan. I have the same response. Without knowing Mr.
Fazio and what his intentions are and investment philosophy, it
is hard for me to speculate as to what actions would have been
taken at the time.
Mr. LaTourette. Do you think, when we were talking to Ms.
Richards from the SEC, that perhaps it would at least cause you
to make an inquiry of the investor? Were they sort of this
hyperactive investor that wanted to turn over their account 18
times in six months?
Mr. Kaplan. It is traditional in our industry that our
compliance officers, when they see an account with an unusual
activity, that they will make contacts with the client to
ensure that that trading is consistent with what they want.
Mr. LaTourette. How about you, Mr. Hommel?
Mr. Hommel. I would agree with Mr. Kaplan's statement on
that point.
Mr. LaTourette. Thank you very much. Thank you, Madam
Chairman.
Chairman Kelly. Thank you very much. The questions here, I
know that they seem difficult, but on the other hand, they're
very, very important to us in terms of understanding what has
gone on here and what our need is to respond to this.
I'd like to address a question to you, Mr. Sibears. Since
we know that the SEC had a clear indication of churning in
1993, and the stock exchange performed some review of the
Gruttadauria accounts in 1994 which might have caught him, I
have to ask you, did the NASD ever review specific customer
account statements of Gruttadauria clients?
Mr. Sibears. Chairman Kelly, we have gone back and done an
exhaustive review of the records of the exams that we've
conducted of firms that Mr. Gruttadauria was associated with
and we've not been able to detect any accounts that we have
reviewed in the course of examination program that were
accounts of Mr. Gruttadauria's clients.
Chairman Kelly. Mr. Sibears, I find that a very interesting
statement since there was obviously some question here in 1993.
Again, 1998, there were some flags raised and yet there's no
record of your looking back at what happened here, is that
correct?
Mr. Sibears. Well, we certainly have a record of what
examinations that we conducted that related to the firms in
question, but as Mr. Doherty testified to, the New York Stock
Exchange has a number of firms that are members of the New York
Stock Exchange. I don't believe, at least his oral testimony,
mentioned the fact that some of those firms, in fact, virtually
all of those firms, not everyone, are dual members of the New
York Stock Exchange and the NASD. And we have a very highly
cooperative program between the New York Stock Exchange and the
NASD that is designed to ensure that firms do not receive any
kind of regulatory overlap or unnecessary duplication.
So, for example, in a firm like these that we've been
talking about, when we did our reviews of Cowen and Lehman, our
focus tended to be not on financial issues or operational
issues, but on things that were unique to our jurisdiction such
as municipal underwritings, private securities transactions,
trading of market making rules that are unique to our authority
as a regulator so as to avoid the overlap. So in this kind of
instance, it wouldn't be particularly unusual.
Chairman Kelly. On page 5 of your testimony, sir, you go
into great detail about the number of scams that the NASD has
found that are carried out through the use of bogus post
offices or bogus addresses. You mentioned that you sent a
member alert highlighting that concern to your member firms.
Can you tell me when you sent that member alert?
Mr. Sibears. Yes. We sent that on January 28th and what we
did was--
Chairman Kelly. January 28th of this year?
Mr. Sibears. 2002 and it was posted to our website which
we--is our standing operation procedure now, to get the
broadest attention and audience.
Chairman Kelly. You also mentioned that you revised your
examination procedures with this regard. Can you tell me when
you made those revisions?
Mr. Sibears. That was earlier in this year and the
revisions that we talk about in that testimony were directly
related to the Gruttadauria matter. We did have certainly a
number of very extensive supervisory procedure examination
steps, but those procedures in that exam protocol was refined
as a result of this matter.
Chairman Kelly. All right, thank you very much. I have one
question for all of the witnesses and that is do you think that
the regulators need any new authority to enable them to
specifically detect this type of fraud, the type of fraud that
was demonstrated by Mr. Gruttadauria and I'm asking all of you.
Mr. Lackritz, why don't we start with you?
Mr. Lackritz. Thank you, Madame Chairwoman. We would
strongly support increased resources for enforcement of the SEC
as I mentioned in my testimony. We strongly appreciated and
supported your Committee's action to increase the authorization
of the SEC, specifically for enforcement activity and I think
that's the main area that we would recommend changing.
Chairman Kelly. Mr. Skolnik, have you a comment?
Mr. Skolnik. Madame Chairwoman, I believe that the
securities laws presently in place and the authority that state
regulators, as well as federal regulators and SROs have is
adequate. I do concur, I think that regulators at all levels
probably need more resources to deal with the demands that have
been created by just the vast increase in the number of
investors who have entered our capital markets in the last
couple of decades.
Chairman Kelly. Mr. Sibears?
Mr. Sibears. With the caveat, Madame Chairman, that
hopefully we can supplement the record after we talk about this
a little bit more back at the NASD because I've been thinking
of your question since you asked Mr. Doherty and Ms. Richards.
I think it's an incredibly important question, but it strikes
me that we have very good and very broad authority and the
important thing is the ability to both try to be very proactive
and catch these problems through our processes before they
occur and have the flexibility to very quickly amend our
procedures and refocus our examination and enforcement programs
once something is brought to our attention which, for example,
in this case, we were able to do. But I would hope to be able
to possibly even respond to this while the record is open more
fully.
Chairman Kelly. Mr. Hommel, Mr. Kaplan, would either one of
you like to respond?
Mr. Hommel. We believe that the current regulatory scheme
is adequate to protect the interest of investors. We firmly
believe that actually our compliance systems were the reason
that Mr. Gruttadauria's scheme came to an end.
Chairman Kelly. Mr. Kaplan?
Mr. Kaplan. I would agree that increased resources is
critical for the SEC and its audit function. However, these
regulators cannot be everywhere. They cannot look at every
account and I think each member firm, has an obligation to make
sure that we maintain a review of our clients, a review of our
employees. That obligation is on us as well.
Chairman Kelly. Thank you. Thank you very much. Ms. Tubbs-
Jones, do you have any more questions for this panel?
Ms. Jones. Lots. I only have 5 minutes. Mr. Hommel, did you
say that you believe it was your compliance system that brought
to light the conduct of Mr. Gruttadauria?
Mr. Hommel. We think that our compliance systems
contributed to the fact that he went underground when he did.
Ms. Jones. Now there's a difference in contributing and
bringing to light. You do understand the distinction between
the words?
Mr. Hommel. I didn't mean to say anything other than that
our compliance systems contributed to the fact that he did.
Ms. Jones. I accept that change in your statement, sir. Did
you also say that you had an asset agreement that when the--the
accounts transferred from SG Cowen or whatever the name of the
company--
Mr. Hommel. We purchased assets from SG Cowen. The assets
were the accounts.
Ms. Jones. And did you say that your agreement, in the
agreement you did not accept any liabilities?
Mr. Hommel. No, the agreement we feel is quite clear that
any liabilities that arise from the operation of that business
prior to the closing date of the transaction remained with SG
Cowen.
Ms. Jones. But any liabilities that result from any conduct
after the date of that transaction, you are responsible for?
Mr. Hommel. That's correct.
Ms. Jones. Is that a fair statement?
Mr. Hommel. That is a fair statement.
Ms. Jones. Making that statement then, can you tell me when
you will respond to all these folks seated in the audience for
that liability?
Mr. Hommel. Well, we have responded to some of them, as I
said in my opening statement. We have reached interim
resolutions with some of the clients where we've identified
misappropriated funds. We have credited those clients. If I
may, with respect to the folks in here and many other folks,
we're in a difficult position in that the assets that came over
were pretty much static when they hit Lehman Brothers. That is,
there was no change in their actual financial situation. That
is a generalism, but largely true throughout the 40 accounts
for which false statements were produced.
Ms. Jones. That's your allegation. According to all these
people in the room the accounts have changed significantly
since the time they came from Cowen to Lehman.
Mr. Hommel. I don't know that that's what they say because
when they came in, the false account statements carried very
large balances which over time have not tremendously declined.
Ms. Jones. So you're saying that most of the people in this
room were not damaged by the conduct of Mr. Gruttadauria?
Mr. Hommel. No, I'm not saying that at all.
Ms. Jones. I don't want to press words with you. Let me
move on, okay?
Mr. Lackritz, in your statement, you say that there are
three levels of regulation or supervision in your industry. The
first level is investor protection from the brokerage firm. The
second is the self-regulatory organizations and the third is
the Securities and Exchange Commission.
Mr. Lackritz. Yes.
Ms. Jones. If you were called as an expert witness in the
lawsuit, all of these good folks against Lehman Brothers, what
level and I will ask you in your opinion, based on your
background and experience, sir, at what layer was there a
breakdown? What layer would that be, 1, 2 or 3? A breakdown in
the supervision to avoid what we have in place, the losses we
have in place today, sir.
Mr. Lackritz. That's a very tough question to answer,
Congresswoman.
Ms. Jones. I know I ask tough questions. So give me a tough
answer, sir.
Mr. Lackritz. I'll do my best.
Ms. Jones. Okay.
Mr. Lackritz. I think that's what the litigation and the
enforcement actions are in the process of uncovering right now.
There are facts in each of these circumstances with respect to
each of these firms. Obviously, there was a breakdown in the
system and obviously, this was an incident that--I'm
embarrassed to be here. I'm apologizing on behalf of the
industry to the victims. In terms of--it was a breakdown
throughout the process.
Ms. Jones. So you would assess blame at every level of
supervision? Or responsibility?
Mr. Lackritz. Yes, responsibility certainly.
Ms. Jones. So what would you do to improve, improve every
level?
Mr. Lackritz. I think that we have continually place
emphasis on improving compliance systems and technology in the
firms which we're doing. We have to continue to increase
investor education which we're doing and improve compliance
programs.
Ms. Jones. Thanks. I've got one last round of questions.
Mr. Skolnik, let me back up, real quick. Mr. Hommel, did
you say you didn't learn until very recently about the 1993
case, sir?
Mr. Hommel. That's correct.
Ms. Jones. And Mr. Kaplan, you said the same thing. Is that
correct?
Mr. Kaplan. That is correct.
Ms. Jones. Then Mr. Skolnik, how could every day Joe and
Stephanie call the NASSA or their state security regulator to
find out about Frank Gruttadauria if neither of these companies
who specialize in hiring brokers knew about the 1993 conduct,
sir?
Mr. Skolnik. Congresswoman, it's very clear here that these
investors were vigilant. As we heard today from the testimony
that I think touched us all, they did carefully scrutinize
account statements and did ask, I think Mrs. Stout talked about
how she challenged Mr. Gruttadauria and did ask questions.
One thing investors can do is to contact their state
securities regulator to inquire whether the investment
professional, the stock broker or investment advisor they're
dealing with is properly licensed to be conducting business and
to determine if they have any disciplinary history.
In this case, unfortunately, it would not have necessarily
have detected any wrongdoing on behalf of Mr. Gruttadauria
because he did not have a disciplinary record. However, in a
lot of cases, a lot of enforcement cases and investigations
that we initiate, we see situations where if investors had
taken the opportunity to contact a state securities regulator,
they would have learned that the investment professional they
are dealing with may have had a disciplinary record or worse
yet, maybe was not even properly licensed to conduct business.
Chairman Kelly. Thank you, Ms. Tubbs-Jones.
Ms. Jones. Thank you, Madame Chairwoman.
Chairman Kelly. Mr. LaTourette.
Mr. LaTourette. Thank you, Madame Chairwoman. I'd like to
throw this open to anyone on the panel because it's a question
that comes up from time to time. Is there a recognized rule of
thumb for what the measure of damages should be in the
situation that we find ourselves in today?
Mr. Hommel?
Mr. Hommel. Given the pendency of litigation, I'm a bit
restrained in what I can talk about. There are several theories
of recovery that have been advanced by the plaintiffs.
Mr. LaTourette. I'm not interested in their theories. I
guess I'm wondering in cases that you've encountered during the
course of your career is there sort of a rule of thumb that
this is what this kind of theft is worth?
Mr. Hommel. I've not encountered a case specifically like
this in my career, but I would imagine that in approaching the
situation, what we try to do is define common ground with the
complaining customers' rooted in the actual cash flows. That
has been something that has prevented us from moving along in
the negotiations with some of these folks because, as I said,
the cash flows at Lehman Brothers simply did not exist in many
of these accounts.
Mr. LaTourette. Anyone else have an observation about how
these things are normally taken care of?
Mr. Lackritz. I think that in almost all of these
situations, it's the responsibility of the firm to make their
clients whole or to treat their clients fairly and in almost
all of these situations when they occur and it's very rare that
they occur. I think it's important and I want to stress, the
system actually works very effectively. Unfortunately, there
are these rare instances when this kind of behavior occurs and
when it does, the firms take responsibility to treat their
customers fairly and make them whole in the circumstance.
Mr. LaTourette. And I think as I understood Mr. Hommel, we
can have different definitions of what making them whole means,
but is there any notion in this type of litigation relative to
punitive damages as opposed to negligence or not paying
attention or when someone actually goes out and steals, it's
under your supervision as appears to be the case here, is there
any notion of punitive damages in any of the cases that you're
aware of? If you know. If you don't that's fine. I'm talking to
you, Mr. Lackritz, I'm sorry.
Mr. Lackritz. I'm only aware of punitive damages in very
rare and unusual instances where there's gross and willful
negligence as opposed to failure to supervise or something like
that.
Mr. LaTourette. But in essence, if gross negligence gives
you punitive, I suppose intentional actions are even higher
than gross negligence and the other observation I would make is
that Mr. Hommel has never seen the situation, I guess, I would
describe this as unique, based upon the breadth of his
experience.
Mr. Hommel, let me--you talked about due diligence when
Lehman bought the business from SG Cowen. Can you describe in a
little detail for us what that means and specifically does due
diligence include going into each and every one of Mr.
Gruttadauria's accounts and physically looking at them or not?
Mr. Hommel. No, there would be no reason to go into Mr.
Gruttadauria's accounts at that point. There were almost 100
brokers who came over with accounts that numbered in excess of
60,000, so it would require going into 60,000 accounts which is
fairly impractical. What we did was we reviewed the compliance
records of every one of the brokers who were coming over and
for each broker who had one or more entries on his compliance
record, complaints on his compliance record, we gave them
special scrutiny. We also did an analysis of the customer
complaints throughout the Cowen system and we checked all the
arbitrations and litigations that were pending against any of
the registered representatives in the system.
We looked at the Cowen audits going back several years to
see what was turned up, all of which is, I would submit,
somewhat standard, but in this instance we also took a look at
the New York Stock Exchange report and the New York Stock
Exchange report had several issues that needed to be dealt
with. As we look back, it appeared that a prominent New York
law firm had come in, had assisted Cowen, in addressing those
problems, had made recommendations that were subsequently
adopted and as we looked at that incident as a whole it
appeared to us, not as a red flag, but as an indication that
Cowen had been inspected and corrected.
Mr. LaTourette. When you say that you looked at any
complaints filed against the brokers that came over, we know
today that a complaint was filed against Mr. Gruttadauria in
1993. Are you saying that the only complaints that you looked
at were those that resulted in a finding, some sort of adverse
finding?
Mr. Hommel. No, we looked at complaints that were on the
CRD, the Central Registration Depository. There are certain
requirements that a broker must report, complaints to the CRD,
so we get the broker's registration file, which is the CRD
file, and we see any complaints that have been registered
against that broker. For reasons that were explained before,
apparently, this 1993 incident did not make it on to Mr.
Gruttadauria's compliance record.
Mr. LaTourette. Okay. I thank you. I don't think I have
anything else.
Chairman Kelly. Thank you very much. The Chair notes that
some Members may have additional questions for this Panel and
they may wish to submit them in writing, so without objection
the hearing record is going to remain open for 30 days for
Members to submit written questions and for these witnesses to
place their responses in the record.
The Chair also notes that Mr. Fazio and Ms. Stout have
stayed for this Panel's testimony and let me say that I
sincerely hope for both of them that this hearing and that
their testimony will result in better protections for all
investors. We appreciate the fact that they came such a
distance and took so much time and I think it's incumbent of
all of the agencies that have been here, giving testimony today
that they understand that this is not--it cannot be business as
it has been in the past. We must have better regulatory
oversight so this kind of thing and these kinds of people are
never again damaged. We must have a change. If you need this to
come from the federal government in the form of a law, then we
will do it. We need to do whatever we can to help the people of
this nation feel that they cannot lose their entire savings
when they put their savings in the trust of someone like Mr.
Gruttadauria.
I will excuse the second Panel with our great appreciation
for your time. I want to briefly thank all of the Members and
their staffs, but also I want to thank my counsel, Mr. Andy
Cochran, for his terrific work on this panel and the other
staff here on this Financial Services Committee. They've worked
very hard on this hearing and I thank them for their assistance
in making the hearing possible.
This hearing is now adjourned.
[Whereupon, at 1:00 p.m., the hearing was concluded.]
A P P E N D I X
May 23, 2002
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