UNITED STATES OF AMERICA
COMMODITY FUTURES TRADING COMMISSION
MARK A. FERRIOLA
CFTC Docket No. 98-R114
OPINION AND ORDER
|CARLO SCOTT KEARSE-McNEILL|
Respondent Carlo Scott Kearse-McNeill ("McNeill") appeals from an initial decision that ordered him to pay $50,500 plus interest to complainant Mark A. Ferriola ("Ferriola").1 The Administrative Law Judge ("ALJ") found him liable under Section 4b of the Commodity Exchange Act ("Act") for both fraudulently inducing complainant to open and maintain his options account and trading complainant's account to generate commissions. McNeill asserts that the ALJ should be disqualified for bias. In addition, he challenges both the ALJ's implicit credibility determination and factual assessments as contrary to the record. Complainant urges the Commission to affirm the judge in all respects.
As explained below, based upon our
independent review of the record, we conclude that McNeill violated
Section 4c(b) of the Act and Commission Rule 33.10 through fraudulent
inducement and churning. We decline to award damages at this time,
however, because the record is ambiguous on the amount of damages
already collected by Ferriola. Consequently, we grant complainant 30
days to show cause why the damage award should not be reduced to
$45,050 plus interest.
Ferriola filed his complaint in March 1998. He sought damages of over $53,000 from McNeill, Gray, and Transamerican, a registered introducing broker ("IB").2 In essence, the complaint alleged that McNeill and Gray had (1) fraudulently induced Ferriola to open and maintain his account, and (2) traded the account to generate commissions. Ferriola claimed that McNeill and Gray's conduct violated Section 4b of the Act and that Transamerican was liable for its employees' wrongdoing pursuant to Section 2(a)(1)(A) of the Act. Complainant selected the voluntary decisional process and paid a $50 filing fee.
The complaint alleged that Ferriola had no experience in sophisticated investments when McNeill solicited him to open an account at Transamerican. During the solicitation, McNeill failed to discuss the risks of options trading. He did, however, describe the success his clients were having and assure Ferriola that he would have similar success if he opened an options account and retained McNeill as his account executive. According to the complaint, Ferriola specifically told McNeill that he did not understand the market. In addition, it alleged that complainant trusted McNeill to handle and protect his funds in a professional manner
The complaint indicated that Ferriola opened his Transamerican account and deposited $20,000 on March 28, 1996. On the same day, complainant purchased the 20 July unleaded gas call options that McNeill had recommended. Ferriola maintained his account until July 1996, and made separate $20,000 deposits on April 1, April 11, and May 2. Complainant claimed that McNeill downplayed the risk and promised that he would protect complainant's investment. Moreover, when the value of his account fell, McNeill offered assurances that losses would be recovered. Complainant also claimed that both McNeill and Gray urged him to borrow money against his credit cards to make his fourth $20,000 deposit.
The complaint alleged that each of the trades in Ferriola's account was based on McNeill's recommendation. It noted that McNeill traded several different commodities and generally selected large positions that generated substantial commissions. Ferriola acknowledged that several of McNeill's April trades were profitable, but emphasized that these profits were immediately reinvested in the market. He alleged that he paid almost $7,000 in commissions and fees in March, $25,000 in April, and $22,000 in May. By the time he closed his account in July, Ferriola had paid commissions and fees of $55,645 and suffered a net loss of $53,105.
McNeill and Gray filed a joint answer in May 1998.3 Both respondents generally denied complainant's allegations of wrongdoing. Gray denied that he had either made trades for Ferriola's account or advised him about how his account should be traded. McNeill alleged that he had informed complainant that futures trading involved a high degree of risk and could result in substantial losses, as well as substantial gains, in a short period of time. The answer also emphasized that Ferriola had a net worth of $1,000,000, had approved each trade in advance, had been kept apprised of the value of his account at all times, and had failed to stop trading when the account was profitable.
After the case was assigned to an ALJ, he
issued an order establishing discovery procedures and a deadline for
submitting prehearing memoranda. During the discovery period,
Ferriola, Gray and McNeill exchanged discovery requests. In
September 1998, they submitted prehearing memoranda focused on the
issues raised in the complaint and answer.
In February 1999, the ALJ conducted a one-day hearing in Chicago, Illinois. Ferriola and McNeill were the only witnesses. Gray did not attend the hearing. Transamerican did not appear.4
Ferriola testified that he had no experience with either securities or futures trading at the time of his initial conversation with McNeill. He said that McNeill called him in March 1996 when he had cash available for investing due to his recent sale of his retail tool business. Complainant testified that his income at that time was $60,000 and that his net worth, excluding his primary residence, was about $175,000. According to Ferriola, when he informed McNeill that he had $20,000 to invest, McNeill convinced him that he could make money trading option contracts. Ferriola claimed that McNeill advised him not to worry because "I [McNeill] will make you tons of money." Transcript at 19.
As a result of this solicitation, Ferriola explained, he filled out the necessary account-opening documents and faxed them to Transamerican on March 27, 1996. He faxed a copy of a check for $20,000 on March 28 and, later in the day, sent the check by Federal Express. According to complainant, he faxed a copy of the check first because McNeill "wanted to start right away." Id. at 21. He explained further that McNeill advised that unleaded gas options were "the best thing to get into at the time." Id. at 22.
Ferriola testified that he submitted an additional $20,000 on April 1 after McNeill told him "[he] could make a lot of money." Id. at 25. Complainant said that he submitted an additional $20,000 on April 8 after McNeill told him that "I can double my money." Id. at 32. Ferriola explained that his fourth $20,000 deposit came from an equity line of credit on his house. He testified that McNeill encouraged him to borrow these funds to increase the funds available for trading. Id. at 36.
Ferriola emphasized that he relied on McNeill's trading advice and described his own approach as going "with the flow." Id. at 23, 25. He acknowledged that he approved each trade in advance, but claimed that McNeill was "basically making his own decisions." Id. at 26. He explained that he trusted McNeill and believed that "if you give a firm that much money, they should take care of you." Id. at 32. Ferriola admitted that sometimes he would respond to McNeill's recommendation with "something different maybe," but explained that he ultimately accepted the advice saying, "if that's the way you want to do it." Id. at 26. Ferriola indicated that he knew that the commission charge would be $160 per contract, but that he was not worried "[b]ecause [he] was told [he] could make some money." Id. at 22.5
During cross-examination, counsel for McNeill and Gray questioned Ferriola about the account-opening documents that he had reviewed and signed. Ferriola acknowledged that he listed his net worth as $1,000,000, although this information was "not right." Id. at 39. Ferriola also admitted that he signed an acknowledgement of risk,6 but explained that he "was just listening to [his] broker basically," id. at 41, and had only "skimmed over" the document because McNeill "got [him] psyched up or fired up or whatever." Id. at 66.
Counsel also questioned Ferriola about
his approval of the trades McNeill made. When queried about his
knowledge of the commission that would be charged for the initial
trade, complainant explained that while he literally knew what the
commission per contract would be, he "actually didn't realize
it." Id. at 46, 22. He explained that his focus was on the
profit he could earn:
"I was not thinking [when the first trade was made] as far as the money I had involved in there. He [McNeill] said 'you have to do it now.' 'Do it now.' 'In the next couple of days you will make so much money.' So I did it. I was not thinking about commissions at the time."
Id. Complainant reiterated his claim that he followed McNeill's recommendations because he "had trust in him basically," id., but did acknowledge that he had asked McNeill "[a] lot of things," id. at 47, and received undated crop reports to review. Id.
When questioned about his knowledge of the risk of loss, Ferriola conceded that it was "possible" that he knew that he could lose money just as quickly as he had made it. Id. at 52. He acknowledged that he did not order his account liquidated when it showed a profit of almost $9,000 on April 11, but noted that McNeill "kept finding different things for me to buy." Id. at 53. He also admitted that the value of his account had fallen by almost $16,000 by April 19, but explained that he had discussed the losses with McNeill and been assured that he "[would] bring [me] back." Id. He also testified that sometime between April 19 and May 3 he advised McNeill that he wanted to get out of some of his positions, but that McNeill talked him into staying with an assurance that "[w]e are coming back." Id. at 56, 52.
Complainant offered limited testimony about Gray's role in the trading of his account. When questioned about the complaint's allegation that Ferriola borrowed the final $20,000 he deposited in his account on May 2 based on representations made by Gray, Ferriola claimed that "[s]ome dates are messed up here." Id. at 60. When asked whether his conversations with Gray were not later, at the time complainant wanted to close his account, Ferriola observed that: "I talked to him occasionally." Id. at 61.
Finally, counsel asked complainant about
the quality of his recollection of McNeill's representations about
profit expectations. Counsel noted that Ferriola modified many of his
answers with the term "basically" and suggested that
complainant was not providing a word-for-word description of
McNeill's representations. Complainant acknowledged that this was
true but insisted that "it's similar though." Id.
at 49. Counsel then focused on Ferriola's testimony that McNeill
had represented that he could double his money:
Q. Okay. So it was your understanding that you could double your money, not that you would double your money? (emphasis added).
A. I was told - yeah, right. Exactly.
Q. You could double your money?
A. No. 'I will definitely get your money back.'
McNeill testified that he advised Ferriola that trading options on commodity futures was a "high risk venture." Id. at 94. He explained that he followed a balanced approach, advising complainant that "you can make money doing this and lose money." Id. at 95. He acknowledged offering his opinion about profit opportunities, but denied that he guaranteed any profit, definitively stated that complainant would make a specific number of dollars on a trade, or claimed that he would double complainant's money. Id. He also denied encouraging Ferriola to borrow money for options trading. Id. at 96.
McNeill also testified regarding Gray's conversations with Ferriola, claiming that he had listened in on every telephone conversation between Gray and complainant. Id. at 97-98. He testified that Gray did not instruct complainant to borrow money to trade options. Id. at 98. He also declared that he never heard Gray offer Ferriola any trade recommendations. Id. at 109.8
Ferriola's counsel focused his examination on McNeill's qualifications and his rationale for frequently trading large positions in out-of-the-money ("OTM") options.9 McNeill testified that he was a high school graduate whose formal futures-related training consisted of taking preparatory courses for the Series 3 examination. Id. at 81-82. He emphasized, however, that he used sources such as the Wall Street Journal, The Financial Times and CNBC and had been analyzing markets long enough "to be considered an analyst." Id. at 82-83.
In response to questions about the basis for the initial trade he recommended, McNeill stated that he recommended a 20 contract position in unleaded gas options because he wanted to control about 1 million gallons of unleaded gas. He believed this level of leverage was appropriate because "in options leverage makes money when the option moves in your favor." Id. at 85-86. When asked about his urgency to enter this trade so quickly, McNeill explained that "we had looked at unleaded gas, and it was spring." Id. at 90.10 Asked his rationale for recommending OTM options rather than in-the-money ("ITM") options, McNeill emphasized that one could gain extra "leverage" by purchasing OTM options - "I explained that the closer to the money you go the more you have to pay in premium so the less contracts you get and less leverage you get." Id. at 91.
McNeill insisted that he based every trade recommendation solely on his assessment of the client's best interests, including the potential effect of the commissions on the client's account. Id. at 71. As to his overall trading methodology, McNeill explained that he based his recommendations on "[m]any things" such as "current events, earthquakes, death, destruction, famine, flood, drought, Saddam Hussein, Whitewater, Monica Lewinsky. You know, on and on and on." Id. at 76. He added that, although he could not recall specific instances, occasionally Ferriola would make suggestions based on what he read in the newspapers, and sometimes McNeill would follow up accordingly. Id. at 76-77.
Asked if he had ever advised Ferriola to
take cash out of his account, McNeill responded
"[s]ometimes," but then described a discussion of possible
options -- "I let him know that he had the option to do whatever
he wanted to do . . . . If you like you can take your money out at any
time." Id. at 87. The ALJ sought to follow up by asking
McNeill how many of his customers had closed their accounts with
profits.11 McNeill initially
sidestepped the question and stated that "there were clients that
took profits from the trades we made. Plenty of them." Id.
at 92. When the ALJ pressed him for verification that 20 or 50 percent
of his customers had closed their account with profits, McNeill simply
responded that he "didn't say that, no." Id. at
After both sides submitted post-hearing briefs, the ALJ issued an Initial Decision dismissing Ferriola's claims against respondent Gray but ordering respondent McNeill to pay complainant over $50,000 in damages. Ferriola v. Transamerican First Corp., [1998-1999 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 27,631 (May 14, 1999) ("I.D."). The ALJ did not explicitly discuss complainant's credibility, but he found that McNeill "was not a credible witness," id. at 47,990, and adopted Ferriola's version of events when it conflicted with McNeill's version of events.12 Moreover, the ALJ did not impugn Ferriola's credibility in explaining his dismissal of the claim against Gray.13
The ALJ found that McNeill induced complainant to open an account with Transamerican by assuring him that he could earn "tons of money" and creating a false sense of urgency by emphasizing the alleged seasonal nature of the unleaded gas market. I.D. at 47,988-89. The judge ruled that McNeill's conduct created in Ferriola's mind the false impression that a "large return on [his] investment" was a "reasonable expectation." Id. at 47,990. He also found that McNeill induced complainant to submit his third $20,000 check by telling him that "he could double his money." Id. at 47,989.14
The ALJ made limited findings relevant to the issue of McNeill's control over the trading in complainant's account. He noted that (1) counsel for McNeill and Gray stipulated that McNeill recommended each trade and (2) McNeill testified that he managed the account. I.D. at 47,989-90.
As to the excessive nature of the
trading, the ALJ noted that McNeill traded eight different option
contracts, consistently employed every dollar available for trading,
and, over a three-month period, converted nearly 70 percent of
Ferriola's $80,000 investment into commissions. I.D. at 47,990. He
also observed that McNeill traded the account when it was
"undermargined" (i.e., he began trading before
Ferriola had deposited any money) and generated a
"commission-to-ratio [sic] that far exceed[ed] 20 percent per
month." Id. Moreover, the ALJ stressed that McNeill's
explanation for why trading in OTM options was advantageous for the
customer -- the availability of increased leverage due to the lower
premium -- ignored the salient fact that the commission charge for OTM
options is precisely the same as that for ITM options. Id. at
47,989. Indeed, the ALJ concluded that:
The strategy McNeill followed was to purchase low premium deep [OTM] options as this generated more commissions than options [ITM] or even near the money.
I.D. at 47,990.
In light of this analysis, the ALJ concluded that McNeill violated Section 4b of the Act and ordered him to pay complainant $50,500 ($56,800 in commissions less the $6500 Transamerican paid Ferriola plus $200 for his filing fee) and interest. I.D. at 47,990. He ruled that complainant's release of Transamerican for $6500 precluded an award against the company. Id.15
On appeal, respondent McNeill argues that
the ALJ should be disqualified due to his bias against the futures
industry. He also challenges the ALJ's implicit endorsement of
Ferriola's credibility and related factual assessments as
one-sided. In particular, he contends that the judge failed to give
appropriate weight to facts that reflect negatively on Ferriola's
case and argues that a balanced review of the record shows that
Ferriola failed to prove either his fraudulent inducement or churning
McNeill argues that a statement that the ALJ made at the oral hearing demonstrates that he is biased against the futures industry. As noted above, during his questioning of McNeill, the judge remarked that "[t]he fix is that 95 percent lose, the other 5 percent lose later." McNeill contends that this remark and the ALJ's conduct during the hearing indicate that the judge believed that a broker does not fulfill his duty to an investor until he makes it clear that the investor will lose all of his or her money. He claims that this amounts to a clear bias against the futures industry that "certainly must have affected his judgment when reviewing the facts of this case." Respondent McNeill's Appeal Brief at 5.
The Commission has held that disqualification of a presiding officer is appropriate when the record establishes that the presiding officer has either (1) a personal bias stemming from an extrajudicial source, or (2) a deep-seated favoritism or antagonism that would make a fair judgment impossible. Kelly v. First Investors Group of the Palm Beaches, Inc., [1994-1996 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 26,753 (CFTC July 25, 1996). Because complainant does not claim that the ALJ's alleged bias arises from an extrajudicial source, we focus on the latter standard.
The remark McNeill cites is insufficient
to raise an inference that the judge harbors a deep-seated antagonism
that would make fair judgment impossible. The Commission has
recognized that intemperate, impatient or inappropriate remarks are
generally insufficient to warrant disqualification. Olson v.
Ulmer, [1990-1992 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶
24,987 at 37,627 (CFTC Jan. 23, 1991) (applying the "pervasive
bias" standard). Neither the ALJ's remark or conduct go
beyond the permissible scope of behavior for a presiding
McNeill also challenges the thoroughness of the ALJ's review of the record in determining credibility and factual issues. As noted above, the ALJ found that McNeill was not a credible witness and adopted Ferriola's version of events when it conflicted with McNeill's version.
The Commission generally defers to the credibility determinations of presiding officers in the absence of clear error. Ricci v. Commonwealth Financial Group, Inc., [1996-1998 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 26,917 at 44,444 (CFTC Dec. 20, 1996). Ideally, given the general nature of complainant's testimony and his limited explanation for falsely claiming a $1 million net worth, the ALJ would have provided an express credibility assessment of Ferriola. Nevertheless, we do not view its absence as an error sufficient to warrant a de novo consideration of credibility.16
Our independent review of the record
establishes that the weight of the evidence supports the findings
necessary to establish the elements of fraudulent inducement and
churning.17 Complainant credibly
testified that McNeill told him that he would make him (Ferriola)
"tons of money." This material misrepresentation created the
false impression that Ferriola could reasonably expect to make a large
return on his investment.18
Ferriola did sign an acknowledgment of risk, but his testimony
establishes that he only skimmed over the document because
McNeill's false representations had gotten him "psyched
up". In any case, respondents' disclosure of the risk of loss
did not cure the deceptive element of McNeill's solicitation by
informing Ferriola that the likelihood of profit was, at best, no
greater than the likelihood of loss. See Bishop v. First Investors
Group of the Palm Beaches, Inc., [1996-1998 Transfer Binder] Comm.
Fut. L. Rep. (CCH) ¶ 27,004 at 44,841 (CFTC March 26, 1997)
(providing the Commission-mandated disclosure statement is not a
general cure for deceptive conduct) ("Bishop").
The record also shows that McNeill lulled Ferriola into submitting an additional $20,000 by telling him that he could double his money. Ferriola's testimony that he honestly did not believe that he could double his money raises a valid question about his reliance on this assurance.19 The fact that Ferriola did not take the statement literally does not establish that he was aware of the truth. In the context of McNeill's earlier misrepresentation, Ferriola could reasonably interpret McNeill's statement as a reiteration of his assurance that significant profits were likely. In these circumstances, McNeill's conduct amounted to lulling.
Throughout this proceeding, respondents have emphasized that complainant would have earned a profit if he had liquidated all his positions at the right time and then ceased trading. On appeal, McNeill raises this point in the context of mitigation. The Commission, however, has held that the duty to mitigate damages does not arise until complainant becomes aware of the underlying wrongdoing. Sansom Refining Co. v. Drexel Burnham Lambert, Inc., [1987-1990 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 24,596 at 36,563-64 (CFTC Feb. 16, 1990). The record does not establish that Ferriola learned that McNeill had deceived him about the likelihood of profit prior to any of the times that he could have liquidated his account at a profit. In these circumstances, McNeill cannot establish the necessary elements of a mitigation defense.
The ALJ found that McNeill controlled the level and frequency of the trading in Ferriola's account and traded the account to generate commissions. On appeal, respondent argues that the record does not support either of these findings. In addition, he criticizes the ALJ for failing to consider the nature of Ferriola's trading objectives in assessing whether the record establishes churning.20
To prove churning, a complainant must show that: (1) respondent controlled the level and frequency of trading in the account, (2) respondent chose an overall volume of trading that was excessive in light of the complainant's trading objectives, and (3) respondent acted with either intent to defraud or in reckless disregard of the customer's interests. Hinch v. Commonwealth Financial Group, Inc., [1996-1998 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 27,056 at 45,020 (CFTC May 13, 1997). Excessive trading of an options account to generate commissions violates Section 4c(b) of the Act and
Commission Rule 33.10. Id.
Because complainant did not execute a written power of attorney, the issue here is whether McNeill exercised de facto control over the level and frequency of the trading in complainant's account. In making this determination, the Commission traditionally looks to evidence that (1) the customer lacks sophistication, (2) the customer lacks prior commodity trading experience and devotes a minimum of time to trading in the account, (3) the customer reposes a high degree of trust and confidence in respondent, (4) a large percentage of the transactions entered for the customer's account are based upon respondent's recommendations; (5) the customer does not approve transactions in advance, and (6) the respondent does not supply full, truthful and accurate information prior to obtaining customer approval for transactions. Proof of control does not require persuasive evidence of each factor and the weight accorded a particular factor may vary with the particular facts and circumstances. Hinch at 45,021.
McNeill emphasizes (1) Ferriola's admission that he knew he would be charged a commission of $160 per trade; (2) Ferriola's admission that he knew he could accept or reject McNeill's recommendations; and (3) evidence that the trading in complainant's account was profitable for some time. McNeill does not explain how the first and third factors raise an inference that Ferriola controlled the trading in his account and we decline to give them significant weight in our analysis.
While the second factor is germane, it is
strongly outweighed by other factors that the Commission has
identified as indicative of control. For instance, the record shows
that Ferriola was relatively unsophisticated and lacked experience
trading either securities or futures at the time he opened his
account. Ferriola credibly testified that he placed a great deal of
trust in McNeill and invariably followed his recommendations. Indeed,
respondent stipulated that all trades were based on his
recommendations. Finally, the record shows that Ferriola's
agreement to McNeill's trading recommendations was influenced by
McNeill's deception concerning the likelihood of profits. In these
circumstances the record supports a finding that McNeill controlled
the trading in Ferriola's account.
McNeill argues that the ALJ's analysis of the nature of the trading is flawed because the judge failed to consider the aggressive nature of Ferriola's trading objectives. The Commission's caselaw recognizes that customer objectives are one of the touchstones for an analysis of excessiveness. In re Murlas Commodities, Inc., [1994-1996 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 26,485 at 43,156-57 (CFTC Sept. 1, 1995). Nothing in the record suggests that Ferriola communicated a specific trading objective to McNeill. In these circumstances, McNeill reasonably could have inferred that Ferriola's trading objective did not narrowly confine the trading strategies McNeill could legitimately pursue.
Nevertheless, the absence of a specific trading objective does not justify the use of a trading strategy that emphasizes the account executive's interests over those of his customer. The Commission's analysis in Murlas recognizes that excessive trading can take place even when a customer has an aggressive trading objective. Murlas at 43,157. While the Commission has traditionally relied upon several factors in assessing evidence of excessive trading in the context of futures trading, the parties have not developed the record on those factors in this case.21 Commission precedent, however, recognizes that proof of these factors is not necessarily required in the context of options trading. Hinch, at 45,021-22.
The record shows that McNeill's trading strategy focused almost exclusively on purchases of large positions in OTM option contracts. McNeill favored trades in positions that were substantially out-of-the-money, even when comparable ITM positions were generally available. Because the premium for an OTM option is lower than the premium for a comparable ITM option, McNeill was able to increase the account's "leverage" by focusing on purchases of OTM options.22
Because Transamerican calculated the commissions it charged Ferriola based on the number of contracts traded rather than the overall value of the position, however, McNeill's consistent focus on large positions in OTM option contracts also increased respondents' income from commissions.23 It is notable that McNeill's explanation for his focus on OTM options cited the increased leverage inherent in his strategy but failed to acknowledge the increased stream of commission revenue it generated.
When purchasing long option positions customers often may achieve a comparable risk/reward posture by purchasing fewer ITM options of the same type and total value, rather than more OTM options of the same type and total
value.24 In these circumstances, the increased leverage inherent in the OTM position is an illusory benefit. Consequently, when customers are paying commissions on a per-contract basis, an account executive seeking to serve his customer's interests will purchase the lower-cost ITM position.
Our review of the record shows that in several instances, McNeill could have purchased lower-cost ITM positions with a comparable risk/reward posture than the OTM positions he actually purchased for Ferriola's account.25 These examples raise an inference that McNeill's focus on purchases of large positions in OTM options for Ferriola's account was not designed to serve his customer's interests. The record also shows that McNeill traded eight different option contracts, consistently employed every dollar available for trading, and, over a three-month period, converted nearly 70 percent of Ferriola's $80,000 investment into commissions. Moreover, McNeill's testimony that he selected trades based on current events such as "Whitewater and Monica Lewinsky" is impossible to square with his claims that he pursued Ferriola's financial interests in good faith.
In light of this evidence, we conclude
that McNeill controlled the trading in complainant's account and
traded excessively in order to generate commissions. As a result, he
violated Section 4c(b) of the Act and Commission Rule 33.10.26
After the ALJ issued his Initial Decision, a dispute arose over the amount of Ferriola's damages that remain unpaid. In awarding complainant $50,500,27 the ALJ took account of Ferriola's receipt of $6,500 as the result of a settlement agreement with respondent Transamerican. In addition, in July 1999, counsel for Vision, the FCM that cleared trades for Transamerican, submitted a letter indicating that Vision had already paid Ferriola $5,300 in light of allegations of wrongdoing raised prior to the filing of Ferriola's complaint.28 Counsel for Ferriola responded with a letter acknowledging receipt of the payment, but claiming that the settlement between Ferriola and Vision was not relevant because it was not "between parties to this litigation."
Counsel's response is insufficient to rebut an inference that Vision's $5,300 payment effectively reduced complainant's out-of-pocket loss for the wrongdoing at issue in this case. In light of the record's ambiguity, however, we grant complainant 30 days to show cause why his damage award against McNeill should not be reduced to $45,050 plus interest. If complainant fails to submit a timely response, the Commission's General Counsel, or his designee, may issue an order adopting this Opinion and Order as a final decision awarding complainant $45,050 plus interest.
IT IS SO ORDERED.
By the Commission (Chairman RAINER, and Commissioners HOLUM, SPEARS, NEWSOME, and ERICKSON).
Jean A. Webb
Secretary of the Commission
Commodity Futures Trading Commission
Dated: June 30, 2000
1 Complainant settled with respondent Transamerican First Corp. ("Transamerican") for $6,500. He did not appeal from the Administrative Law Judge's dismissal of his claim against respondent Albert Gray ("Gray").
2 Account statements attached to the complaint indicate that Transamerican traded Ferriola's account through Vision L.P. ("Vision"), a registered futures commission merchant ("FCM").
3 Respondents elected the formal decisional process and paid the required filing fee pursuant to Commission Rule 12.25(b)(2).
Transamerican had previously filed an answer generally denying complainant's allegations. It later reached an agreement with Ferriola to settle his claims for $6,500. The ALJ dismissed the complaint as to Transamerican on the basis of this settlement. The ALJ later vacated his dismissal and reinstated Transamerican as a party to the proceeding as a result of a discovery dispute raised by McNeill and Gray. In his Initial Decision, the judge again dismissed the complaint as to Transamerican in light of the settlement agreement.
4 As indicated above, because of the ongoing discovery dispute between Transamerican and respondents McNeill and Gray, the ALJ treated Transamerican as an active participant in the case despite its settlement with Ferriola.
5 The parties' counsels stipulated that the account statements accurately reflected the trading losses and commissions incurred. Transcript at 37. Respondents' counsel stipulated that, with the exception of the trade liquidating open positions when Ferriola directed that his account be closed, all trades in complainant's account were based on McNeill's recommendations. Id. at 29.
The risk acknowledgment stated that:
Customer acknowledges that investments in futures contracts are speculative, involve a high degree of risk and are suitable only for persons who can afford to lose all the funds invested.
Transcript at 41.
7 At an earlier point, counsel asked Ferriola whether he believed that he could double his money in a short period of time. Complainant responded that he "honestly didn't believe it, but I was told I could." Id. at 45.
8 In response to questions from complainant's counsel, McNeill acknowledged that Gray had spoken to Ferriola about keeping his account open. He denied, however, that Gray had received a share in the commissions generated by trading in Ferriola's account. Id. at 111-12.
9 Out-of-the-money is a term used to describe an option that has no intrinsic value. For example, a call at $400 on gold trading at $390 is out-of-the-money ten dollars. In-the-money is a term used to describe an option contract that has a positive value if exercised. A call at $400 on gold trading at $410, for instance, is in-the-money ten dollars. CFTC Glossary: A Layman's Guide to the Language of the Futures Industry (1997).
10 In response to an earlier question about this
trade, McNeill noted that it was "driving season" and
Unleaded gas is a seasonal trade. If you look at the track record sometimes it wins and sometimes it doesn't. Based on information I had supplies being low at that particular time I thought it was going to go up.
Transcript at 81.
11 During this questioning McNeill commented that it was generally understood in the futures business that there was sufficient liquidity to permit a customer to take profits "[a]ny day." Id. at 91. The ALJ responded with the remark "[t]he fix is that 95 percent lose, the other 5 percent lose later." Id.
12 Illustratively, the ALJ found that McNeill "assured" Ferriola that he could make "tons of money." I.D. at 47,988. Similarly, the ALJ found that both McNeill and Gray had urged Ferriola to borrow the final $20,000 deposited in his account. Id. at 47,989.
13 The ALJ essentially bypassed the question of liability and held that there was insufficient evidence that complainant suffered any damages due to Gray's wrongdoing. I.D. at 47,990.
14 The ALJ also ruled that McNeill's own testimony conclusively proved that he fraudulently induced Ferriola to open his account. He did not, however, cite to a particular aspect of McNeill's testimony. Instead, the judge emphasized that McNeill "virtually conceded" that most of his clients experienced losses when they closed their accounts. I.D. at 47,990.
15 Earlier in his decision, the ALJ found, incorrectly, that Vision had guaranteed Transamerican and stated that Vision was "liable for any judgment rendered against Transamerican or its agents and in favor of a customer." I.D. at 47,989. As discussed below, this finding has led to a dispute on appeal about the proper amount of damages payable to Ferriola.
16 McNeill does not point to any error in the ALJ's assessment of his own credibility, and our review of the record does not suggest any defect in this aspect of the ALJ's decision.
17 Our factual assessments diverge from those of the ALJ in several respects. For example, as discussed below, we have weighed the significance of Ferriola's testimony that he honestly did not believe that he could double his money. Moreover, we conclude that the record does not support the ALJ's findings that McNeill's testimony (1) conceded that he managed complainant's account, and (2) proved that he fraudulently induced Ferriola to open and maintain his account.
18 As noted above, Ferriola candidly acknowledged that his testimony did not describe McNeill's testimony "word-for-word." His recollection was sufficiently specific, however, to reliably establish the nature of McNeill's fraudulent conduct. Compare Krueger v. The Sage Group, Inc., [1987-1990 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 24,566 (CFTC Dec. 14, 1989) ("The lack of specificity in complainant's allegations undermines the weight properly attributable to them").
19 In the circumstances of this case, however, respondent places undue emphasis on the significance of representing that a customer "could" double his money rather than representing that he "would" double his money. In similar circumstances, the Commission has recognized that a customer may be deceived even when elements of a challenged statement are literally true. Bishop, at 44,841.
20 McNeill's argument that Ferriola's complaint did not raise a churning claim is frivolous. As noted above, the complaint clearly alleges that "[t]rades generated by McNeill and Gray were not generated to benefit Ferriola, rather they were generated to earn commissions for [respondents]." Complaint, ¶ 23.
21 The relevant, but non-exclusive, factors that indicate excessive futures trading include: (1) high monthly commission to equity ratios, (2) a high percentage of day trades, (3) the broker's departure from a previously agreed upon strategy, (4) trading in the account while it was undermargined, and (5) in and out trading. In re Paragon Futures Ass'n, [1990-1992 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 25,266 at 38,847 (CFTC April 1, 1992). While the ALJ purported to analyze the account's monthly commission-to-equity ratio, he does not explain where the numbers he cites come from and the parties did not submit any estimates of the ratios.
22 This "leverage" rationale ignores the fact that, all things being equal, the value of a low priced option is less responsive to changes in the price of the underlying commodity or other asset than is a higher priced option. For the same $10,000 the account might purchase ten OTM option contracts @ $1,000 each rather than two ITM options @ $5,000 each, but the sensitivity of the two positions to changes in the underlying commodity value may be quite similar.
23 Illustratively, if Transamerican charged a commission of $100 per contract in the circumstances described in the above example, Ferriola would pay a commission of $1,000 for the OTM position and only $200 for the ITM position.
24 The value of an option is its premium, that is, the option's market price at a given time. The premium is dependent upon the option's strike price relative to the market value of the option's underlying commodity or security, the option's time to maturity, prevailing interest rates and the volatility of the underlying instrument. An option's premium also represents the total risk associated with its purchase -- i.e., the most that the purchaser can lose. Thus, two portfolios consisting only of long option positions with the same total premium value present equal risk, no matter how many individual options each portfolio contains.
An option's profit potential is measured by its delta -- that is, the sensitivity of an option's premium to changes in the value of the underlying instrument or commodity. Specifically, the delta shows the change in the value of the option for a small change in the value of the instrument underlying the option. A call (put) option's delta varies between zero and one (zero and minus one). It approaches zero the farther the option is out-of-the-money and approaches one (minus one) the farther it is in-the-money. Moreover, the profit potential of a given OTM option, as measured by its delta, is lower than that of an otherwise identical ITM option. That is essentially why the latter is more valuable than the former. This would appear to suggest that a portfolio of long OTM options will not only be of comparable risk to an equally valuable portfolio of fewer ITM options, but that it also may have comparable profit potential. In fact, the portfolio containing the smaller number of ITM options will always exhibit a greater profit potential than an equally valuable portfolio containing a larger number of sufficiently OTM options.
25 For example, on March 28, 1996, McNeill purchased 20 July 96 unleaded gas calls with a strike price of $66 at $.01.95 per gallon per call, for a total premium of $16,380. Commissions (at $160 per contract) totaled $3,200. Because the July 96 unleaded gas futures price stood at $61.38 that day, the 66 call was over $5.50 out-of the-money. If, instead of the July 96 options with a $66 strike price, McNeill had purchased $16,380 worth of July 96 calls at a strike price of $63. and a premium of $.02.95 per gallon per call, only 13 contracts (16,380/(.02.95*42000)), would have been required to obtain the same risk exposure. Ferriola would have saved over $1,100 (7 fewer contracts @ $160 apiece) on the latter transaction.
On the following day, March 29, 1996, McNeill purchased 21 July 1996 soybean call options with a strike price of $8.00 at $.16 per bushel per option for a total premium of $16,800 and commissions of $3,360. Since the July 1996 soybean futures price was $7.45 on that date, the purchased option was $.55 OTM. If McNeill had used the same amount of premium to buy the ITM July 1996 soybean call with a strike price of $7.25, only about nine options would have been purchased for a commission charge of $1,440. Ferriola would have saved $1,920 on the latter transaction.
On April 9, 1996, McNeill purchased 20 July 1996 sugar call options with a strike price of $11.50 at a premium per option of $.0041 per pound. Total premiums paid for this position amounted to $9,184 and total commissions were $3,200. The futures price on this day was $11.36. If, instead, the $9,184 had been used to purchase July 1996 calls with a strike price of $11.00 at a premium of $.0061 per pound per option, about 13 contracts would have been purchased. Ferriola would have saved $1,120 on the latter transaction.
On May 7, 1996, 30 July 1996 wheat call options with a strike price of $6.00 were bought for $.17 and $.19 per bushel per option for a total premium of $27,500 and total commissions of $4,800. Since the futures price for wheat that day was $5.56, these options were $.44 out-of-the-money. If the July 1996 wheat calls with a strike price of $5.50 had been purchased instead, the premium would have been $.35 per bushel per option and $27,500 could have bought 15 options. Ferriola would have saved $2,400 on the latter transaction.
26 The complaint alleged that both McNeill`s churning and fraudulent inducement activity violated Section 4b of the Act. Because McNeill traded commodity options, however, Section 4c(b) of the Act and Commission Rule 33.10 are more appropriate bases for an award. McNeill is not prejudiced by our change in the statutory basis for his violations, because the elements of proof for fraudulent inducement and churning do not depend on whether the instrument at issue is a commodity option contract rather than a commodity futures contract. In re Staryk, [1996-1998 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 27,206 at 45,810 (CFTC Dec. 18, 1997).
27 The ALJ awarded Ferriola $50,300 in damages and $200 for the filing fee he allegedly paid. The record, however, reflects that Ferriola only paid a $50 filing fee.
28 Counsel also noted that the ALJ had erred in finding that Vision had guaranteed Transamerican. Commission records also reflect that Transamerican was never guaranteed by Vision.