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.

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