Thursday, March 18, 2010

Ninth Circuit Court of Appeals Addresses “Scienter” Requirement Under Securities Exchange Act of 1934 and Rule 10b-5

On February 17, 2010, the Ninth Circuit Court of Appeals issued a decision addressing the “scienter” requirement for securities fraud under Securities Exchange Act of 1934 and Rule 10b-5. “To establish a violation of section 10(b) and Rule 10b-5, the SEC is required to ‘show that there has been a misstatement or omission of material fact, made with scienter.’” Ponce v. SEC, 345 F.3d 722, 729 (9th Cir. 2003) (quoting SEC v. Fehn, 97 F.3d 1276, 1289 (9th Cir. 1996)).

In the case, the NASD found that Alvin and Donna Gebhart, securities salespersons, committed securities fraud by making false statements to clients in connection with the sale of promissory notes used to finance the conversion of mobile home parks to resident ownership. The Gebharts sold the promissory notes to their clients without conducting any independent investigation into the program. They failed to obtain any financial statements, to ascertain who the owners, officers, or shareholders of the company performing the conversion were, to determine what compensation would be paid to the company or their officers, or to verify that trust deeds securing the notes being recorded or obtain copies of recorded trust deeds. In lieu of an independent investigation, the Gebharts relied on the representations of a former associate of Alvin Gebhart.

Between October 1996 and the program’s collapse in 2000, the Gebharts sold nearly $2.4 million in promissory notes to 45 of their clients, earning about $105,000 in commission. The sales were based on several statements by the Gebharts that, it later became clear, were false. The Gebharts told their clients that the notes were a proven investment that offered substantial returns and were secured by recorded deeds of trust. They said that in the worst case scenario their clients would be part owners of the mobile home parks and would be able to recover their investments. In fact, the trust deeds were not recorded and the parks were significantly over-encumbered.

The Gebharts failed to disclose that their statements were based on information provided by someone to them rather than through their own, independent investigation. At the time of the collapse of the program in the middle of 2000, there were approximately $3,670,000 in outstanding promissory notes, of which only $605,000 were secured by recorded deeds of trust. At the time, the Gebharts’ clients had over $1.5 million invested in outstanding notes.

As a result of these events, in 2002 the NASD’s Department of Enforcement filed a complaint against the Gebharts asserting that the Gebharts had made materially false and misleading statements to their clients in violation of section 10(b) of the Securities Exchange Act of 1934, SEC Rule 10b-5 and NASD Conduct Rule 2120. A NASD hearing panel found that the Gebharts had acted in good faith and therefore rejected the fraud charges, but the NASD National Adjudicatory Council (NAC) reversed. The NAC found that the Gebharts had committed fraud, imposed a lifetime bar on Alvin Gebhart and imposed a one-year suspension and a $15,000 fine on Donna Gebhart.

The Gebharts challenged the decision, and the case eventually came before the Ninth Circuit on their petition for review. The Gebharts contended that 1) the SEC applied an erroneous legal standard for scienter, and 2) the SEC’s finding of scienter was not supported by substantial evidence.

With regard to the first issue, the court noted that scienter may be established by showing that the defendants knew their statements were false, or by showing that defendants were reckless as to the truth or falsity of their statements. Although the Court could consider the objective unreasonableness of the defendants’ conduct to raise an inference of scienter, the ultimate question was whether the defendant knew his or her statements were false, or was consciously reckless as to their truth or falsity.

The court noted that the SEC certainly considered the objective unreasonableness of the Gebharts’ actions as part of its analysis. The Gebharts made “no effort” to corroborate the representations that the parks were not overly encumbered. The SEC recognized that scienter turned on “an actor’s actual state of mind at the time of the relevant conduct.” Based on the evidence as a whole, the SEC determined that the Gebharts “knew they had no direct knowledge of the truth or falsity” of their statements, and made their statements “despite not knowing whether they were true or false.” The court determined that the SEC correctly applied the appropriate scienter standard.

With regard to the second issue, the Gebharts also argued that the SEC’s finding that they acted with scienter was not supported by substantial evidence. The substantial evidence standard applies to the SEC’s finding of scienter, and means more than a mere scintilla but less than a preponderance of evidence. In other words, it means such relevant evidence as a reasonable mind might accept as adequate to support a conclusion.

The Gebharts pointed out that there was some evidence supporting an inference that they genuinely believed that they had an adequate basis for their statements. Significantly, the Gebharts themselves invested substantially in the notes. See 8 Louis Loss & Joel Seligman, Securities Regulation 3691 n.558 (“[I]nvestment of one’s own money tends to negate scienter, since it ‘belies any known or obvious danger.’ ” (quoting Hoffman v. Estabrook & Co., 587 F.2d 509, 517 (1st Cir. 1978))). Substantial evidence, however, supported the SEC’s finding of recklessness. The Gebharts based their statements on representations by Mr. Gebhart’s former associate and conducted no meaningful independent investigation to confirm the truth of their representations. It was therefore reasonable for the SEC to infer that the Gebharts were consciously aware that they lacked sufficient information for their statements.

Friday, March 12, 2010


In December 2009, the Financial Industry Regulatory Authority (“FINRA”) proposed changes to the consolidated FINRA rulebook, which incorporated the National Association of Securities Dealers (“NASD”) rules on registration and qualifications. These changes were proposed pursuant to FINRA Regulatory Notice 09-70: “FINRA Requests Comment on Proposed Consolidated Registration and Qualification Requirements” (“Proposal”).

Essentially, the purpose of the Proposal is to streamline NASD Rules 1021 and 1031. Under the NASD, these rules governed registration requirements of representatives and principals. Under current FINRA rules, investment bankers and broker-dealers of FINRA member firms must register. Additionally, FINRA member firms may register any individuals that engage in legal, compliance, internal audit, or back-office operations. The primary effect of the proposal would significantly broaden the current “permissive” registration categories to allow member firms to register certain persons employed by member firms or their financial services affiliates. Because of this expansion, FINRA also would introduce new stand-alone registration categories:

(1) active registration, for individuals engaged in investment banking or securities activities

(2) inactive registration, for individuals engaged in the “bona fide” business purpose of the member

(3) retained associate registration, for individuals functioning as financial services affiliates.

The actual text of the Proposal can be accessed here.

The comment period was slated to end February 1, 2010, but was extended to March 1, 2010. Twenty-one organizations submitted comments, voicing opinions ranging from full support to complete abandonment. The organizations included investment firms such as Edward Jones and T.Rowe Price and industry associations like the North American Securities Administrators Association, Inc. (“NASAA”) and the Securities Investment and Financial Markets Association (“SIFMA”). Most of the comments voiced general overall support, but suggested small changes to help effectuate a more efficient transition. See SIFMA Comment and Edward Jones Comment. The NASAA was one of the few who voiced complete abandonment of the acquisition of NASD rules into the consolidated FINRA rulebook. The primary objection to the Proposal is FINRA’s lack of guidance on the appropriate substance of a registered inactive person’s education and continuing education requirements. However, NASAA suggests this issue could be solved by continued use of FINRA’s current qualification examination waiver process, which would be superseded by the new rules. Further, the NASAA believes these three new registration categories constitute radical changes that are structured for the convenience of member firms not investor protection.

FINRA has not yet filed its rule proposal with the Securities and Exchange Commission, which may suggest the organization will make changes before its submission.

Friday, March 5, 2010


The Florida Office of Financial Regulation (“Office”) recently updated some of its securities rules. The Office submitted notice for several proposed rule changes that are primarily to keep its rules up-to-date with the most current federal laws and cross references. For example, references to NASD had to be switched to FINRA after the SEC approved their consolidation back in 2007. Despite these “housekeeping” changes, there are a few noteworthy proposals that are substantive in nature. The substantive proposals come pursuant to House Bill 483 that passed during the 2009 Florida legislative session. The purpose of the bill was to increase investor protection through an expansion of certain agency powers. House Bill 483 became effective July 1, 2009, but the Office of Financial Regulation is beginning to submit its proposals for the supplementary rules.

One such substantive change is Proposed Rule 69W-1000.001, which creates a set of disciplinary guidelines in accordance with House Bill 483. The rule expands the disciplinary power of the Office of Financial Regulation to impose additional sanctions against individuals and firms that are subject to regulation under the Florida Securities and Investor Protection Act (“Securities Act”). Under the new rule, the Office has the power to impose cease and desist orders in conjunction with any sanction laid out in the Securities Act and raises the levels of minimum fines. The rule also sets out an extensive and comprehensive factors list to determine the appropriate sanction.

Proposed Rule 69W-600.0011 was also added pursuant to House Bill 483. Under this proposed rule, applicants could be subject to registration disqualifying periods for dealers, issuer dealers, investment advisors, as well as “relevant persons.” “Relevant persons” for purposes of the rule include “any direct owner, principal, or indirect owner that is required to be reported on behalf of the applicant on a Form BD or a Form ADV.” A Form BD is required for the application for broker-dealer registrations, and a Form ADV is required for applications for investment advisor registration. Grounds for disqualifying periods are based upon criminal convictions, pleas of nolo contendere, and pleas of guilt, regardless of whether there was an adjudication. The disqualifying periods range from five years to fifteen years depending on whether the crime is a classified as “Class A” or “Class B.” Class A crimes are felonies involving an act of fraud, dishonesty, breach of trust, money laundering, and any other crime involving a question of “moral turpitude.” Class B crimes are misdemeanors involving “fraud, dishonest dealing or any other act of moral turpitude.” Pleas receive a disqualifying period of three years. There is also a provision allowing registrants to submit any evidence of mitigating factors that may reduce the length of disqualification.

The Office of Financial Regulation is charged with safeguarding private financial interests of the public through licensing, chartering, examining, and regulating depository and non-depository financial institutions and financial service companies in Florida. It also serves to protect consumers from financial fraud and preserve the integrity of Florida’s markets and financial service industries.

Thursday, March 4, 2010


On March 1, Commodities and Futures Trading Commission (“CFTC”) Chairman, Gary Gensler, spoke to the Institute of International Bankers about over-the-counter (“OTC”) derivatives reform. On March 2, he spoke before the Women in Housing and Finance organization. In his addresses, Mr. Gensler discussed the history of derivative markets, the need for comprehensive regulation in these markets, and the regulatory reforms that should be implemented. The CFTC is charged with monitoring and regulating the futures and commodity options exchanges in order to protect market participants and promote fair trading.

In 1981, the first derivatives transaction took place. Throughout the 1980s, these instruments were tailored one at a time to meet specific risk management requirements of two sophisticated parties—usually a dealer and a corporate customer. Parties negotiated a deal each time they needed to hedge a specific financial risk; they were not widespread public investment tools. Because these transactions did not take place on regulated exchanges, but rather existed purely in company accounting books, the information available to the public about pricing was not readily available. Further, this lack of information made it difficult to understand the magnitude of interconnectedness between financial institutions. Over the next decades, the notion of derivatives as a hedging tool became increasingly popular, causing contracts to be more standardized and easier to negotiate and trade. Upgrades in technology further influenced the popularity of derivatives by facilitating easy electronic trading. At its peak, before the financial crisis, the derivatives market had a notional value of $300 trillion in the U.S., whereas in the 1980s, the notional value of the derivatives market was only $1 trillion.

Since their inception, these financial hedging tools remained largely unregulated. In the aftermath of the financial meltdown, it became known how OTC derivatives can increase risk when unregulated, instead of functioning properly as a risk hedger. Their risk-added is even more dangerous when coupled with the limited availability of pricing information and a lack of transparency. It is for these reasons that Chairman Gensler advocates comprehensive reform of OTC derivatives.

According to Chairman Gensler, there are three main components that will result in effective reform:

  1. Explicitly Regulate Derivatives Dealers
  2. Implement Transparent Trading Requirements
  3. Organize Clearinghouses to Clear Standard Derivatives

Derivative Dealer Regulations. Chairman Gensler believes that having an explicit regulatory framework of derivatives dealers will lower risk. First, the regulations should impose certain capital and margin requirements to mitigate risk to the public. Second, business conduct standards should be put in place to protect against fraud, market manipulation and abuse, which will in turn promote market integrity. Finally, derivatives dealers should have standardized recordkeeping and reporting requirements. Such requirements would bring transparency to the system and provide more accurate pricing information to the public.

Transparency in Trading. Chairman Gensler asserts that trading must be transparent in order to improve how current markets function, create better market liquidity and lower hedging costs. In order to have trading transparency, he advocates that there must be centralized trading venues. These venues would be better equipped to asses and manage risk of OTC derivatives and provide transparency because all derivatives trading would have to have cleared positions based on a reliable market price. The reliable market price would be a by-product of having central trading venues.

Central Clearinghouse for Standard Derivatives. Currently, derivatives are primarily listed on company books, not with a central source, which creates unknown levels of interconnectedness between financial institutions and contributes to the issue of “too big to fail.” Therefore, Chairman Gensler believes that it is imperative to have a central clearinghouse to understand how institutions are connected, because a central clearinghouse would provide transparency about these relationships and reduce interconnectedness of banks since derivatives would flow through the clearinghouse instead of bank balance sheets. It is estimated that 75% of derivatives traded are standard derivatives transactions. Such transactions, because of standardization, can therefore be monitored and cleared though one central clearinghouse. Those derivatives transactions that are highly specialized and tailored would remain outside the scope of the clearinghouse (but within the dealer regulations) and would still be allowed to trade bilaterally. Further, Gensler concedes that there would be other exceptions, but exceptions should remain narrow and explicit.

In closing, Chairman Gensler reiterated the necessity for OTC derivatives regulations because “the central lesson from the crisis is that an interconnected financial system facilitates the spread of risk from institution to institution, threatening the entire economy.”

Currently, the House of Representatives is considering H.R. 3300, the Derivative Trading Accountability and Disclosure Act, which would implement many of the changes Chairman Gensler suggests. The Senate also introduced Senate Bill 3714, Derivatives Trading Integrity Act of 2008, which focused primarily on introducing a regulated exchange for certain types of derivatives. However, that bill was never reconsidered.


On March 2, 2010, the SEC and the IRS executed a Memorandum of Understanding (“MOU”) outlining their commitment to enhance compliance by the municipal securities industry with the rules and regulations each agency is responsible for enforcing. The MOU provides that the SEC and the IRS will work cooperatively to identify issues and industry trends, and develop strategies to enhance performance of each agency’s responsibilities within the tax exempt bonds/municipal securities industry.

The MOU specifically aims to (1) improve coordination and information sharing between the SEC and the IRS, and (2) promote educational and outreach events within the two agencies and the tax exempt bonds/municipal securities industry as a whole. To aid in the agencies’ cooperative efforts, the MOU provides for the creation of a Tax Exempt Bond/Municipal Securities Committee, which will coordinate discussions between the agencies regarding policy, procedure and compliance issues within the industry. In addition, the SEC and IRS agree to share information regarding, among other things, market risks, practices, and events relating to tax exempt bonds/municipal securities that may be of interest to the other agency. The agencies also agree to consider training opportunities addressing laws, policies, procedures and other issues the agencies encounter in completing their respective missions.

Through cooperative relationships such as this, the SEC and other regulatory agencies are better suited to protect investors by ensuring that they obtain the information necessary to make informed investment decisions and by ensuring that the securities industry operates in accordance with the laws put in place to protect investors.

A complete copy of the MOU can be found here.