SECURITIES AND EXCHANGE COMMISSION
SECURITIES EXCHANGE ACT OF 1934
Admin. Proc. File No. 3-9886
In the Matter of
ROBIN BRUCE McNABB
Opinion of the Commission
REGISTERED SECURITIES ASSOCIATION -- REVIEW OF DISCIPLINARY ACTION
Violations of Conduct Rules
Failure to Inform Employer of Private Securities Transactions
Registered principal sold securities in the form of promissory notes to customers without notifying employer. Three of the sales involved unsuitable recommendations. Held, association's findings of violation are sustained in part, and sanctions imposed by association are sustained.
Thomas Breen Kidwell, for Robin Bruce McNabb.
Alden S. Adkins, Norman Sue, Jr., Susan L. Beesley, and Nancy C. Libin, for NASD Regulation, Inc.
Appeal filed: April 30, 1999
Robin Bruce McNabb, formerly associated with American Investors Company ("AIC"), a member of the National Association of Securities Dealers, Inc. ("NASD"), appeals from NASD disciplinary action. The NASD found that McNabb sold securities in the form of promissory notes to six public customers and sold securities in the form of investment contracts to two public customers without giving AIC prior written notification, in violation of NASD Conduct Rules 2110 and 3040. 1 The NASD also found that McNabb recommended the purchase of promissory notes to three of the customers without reasonable grounds for believing that the investments were suitable for them, in violation of NASD Conduct Rules 2110 and 2310. 2 The NASD censured McNabb, fined him $50,000, and barred him from association with any NASD member in any capacity. 3 We base our findings on an independent review of the record.
McNabb entered the securities business in 1981. From February 1990 until December 7, 1995, he was employed by AIC, whose home office is Hayward, California. McNabb, a registered principal, managed an AIC Office of Supervisory Jurisdiction in San Jose, California. He operated the office as an independent contractor under the name of RKM Financial Group ("RKM").
Between February 1994 and May 1995, McNabb borrowed a total of more than $690,000 from six customers, in exchange for ten written promissory notes. The notes had fixed rates of interest, ranging from eleven to seventeen percent. Interest was to be paid monthly. Payment of the principal was due on or before a specific date that ranged from seventeen months to approximately six years from the dateof issuance. 4 One of the notes was secured by a deed of trust on the RKM office suite.
All the customers from whom McNabb borrowed money were long-term clients. McNabb asked the customers for the loans because he needed money to reorganize his business operations, in part due to personal financial problems. All of the money from these loans was used for general business overhead expenses.
In late 1995, AIC initiated an internal investigation of these transactions. 5 During the course of the investigation, McNabb made false and misleading statements to AIC. The investigation resulted in the termination of McNabb's association with AIC, in part on the ground that he had violated a firm policy against accepting loans from customers. 6
Conduct Rule 3040 generally prohibits a person associated with a member firm from effecting securities transactions outside the regular course of employment without giving prior written notice to the firm. 7 McNabb admits that he did not notify AIC of the transactions at issue. He contends, however, that he did not violate Rule 3040 because the promissory notes were not securities.
The term "security" is defined in section 3(a)(10) of the Securities Exchange Act of 1934 as including "any note." 8 The Supreme Court has qualified this definition by adopting a "familyresemblance" test for determining when a note is a security. 9 Under that test, a note is presumed to be a security, unless either an analysis of the note, using four factors identified by the Court, 10 produces the conclusion that the note bears a strong resemblance to certain types of notes recognized as being outside the investment market regulated under the securities laws 11 or, based upon an analysis of the same four factors, the note should be added to the list of notes outside that market.
A. Family Resemblance to Recognized Non-Securities
McNabb asserts that the promissory notes at issue resemble notes evidencing character loans to bank customers or notes evidencing loans by commercial banks for current operations. The Supreme Court has identified such notes as being outside the investment market regulated by the securities laws. 12
We do not find a "family resemblance" between the notes at issue and either notes evidencing character loans to bank customers or notes evidencing loans by commercial banks for current operations. As we have previously noted, "[b]anks are in the business of making loans. Character loans, in particular, are generally given to longstanding, large depositors, whose credit situation is known tothe financial institution." 13 The lenders in this instance were not financial institutions with expertise in assessing lending risks, nor were they in the business of making loans. Although the lenders stated in their declarations that they trusted McNabb to repay the loans, they did not have access to the type of financial or business information that a bank would have about its customers. Nor could the customers analyze McNabb's business operations to the extent that a bank would before lending money for current operations.
We further find that the notes issued by McNabb do not bear a "family resemblance" to any of the other types of notes recognized as being outside the investment market regulated by the securities laws.
B. Addition of These Notes to List of Non-Securities
We also conclude that the four-factor analysis adopted by the Supreme Court does not suggest that the promissory notes should be excluded from regulation under the securities laws.
1. Motivations of Lender and Borrower. The Supreme Court has stated that a note is likely to be a security "[i]f the seller's purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate . . . ." 14 A note that is exchanged "to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller's cash-flow difficulties, or to advance some other commercial or consumer purpose," on the other hand, is less likely to be a security. 15 The test is an objective one, looking to "the motivations that would prompt a reasonable seller and buyer to enter into [the transaction]." 16
We find that McNabb engaged in the transactions at issue in order to raise funds for the general use of his business enterprise, RKM. Indeed, McNabb testified that all money he borrowed was used for general business overhead expenses. 17
We further find that the customers who loaned money to McNabb were motivated by a desire for profit. The customers were to receive interest ranging from eleven to seventeen percent annually, favorable rates compared with those to be expected from the money market funds and certificates of deposit that some of the customers sold in order to engage in the transactions with McNabb. 18 The promise of favorable interest rates "indicates that profit was the primary goal of the lender." 19 In a letter to a customer to whom McNabb had issued a promissory note paying fourteen percent interest, McNabb expressed his "congratulations" on the transaction, apparently suggesting that the terms were favorable to the customer.
The fact that the customers obtained the notes from a financial advisor as part of an investment portfolio is also evidence of investment intent. 20 Several customers used the proceeds fromsales of mutual fund shares for their promissory note transactions with McNabb. Additionally, several customers explicitly compared their arrangements with McNabb to investments in stocks or bonds. In a letter to one investor confirming certain payment terms of one of the notes, McNabb wrote: "[W]e are adjusting your portfolio as required." 21
McNabb contends that his customers were not primarily motivated by a desire for profit, but instead by a desire to help a friend in need. McNabb submitted declarations from five of the six customers with whom he had engaged in the transactions at issue. In these declarations, some of the customers who had loaned McNabb money stated that they regarded him as a friend as well as a trusted financial advisor. Several of the customers also stated that they were motivated to enter into the transactions by a desire to help McNabb. 22 However, the declarations also reflect a desire to enjoy the returns promised. For example, one customer who called the terms of the loans "more than fair" stated that he and his wife "enjoyed receiving the monthly payments rather than having all of our funds wrapped up in equities." Another customer said that she was "grateful" that McNabb borrowed more than $200,000 from her and that she preferred using her money that way to investing it in stocks or bonds "where I might really lose my money." These statements show that the customers were motivated by the desire to earn a profit.
2. Plan of Distribution. McNabb contends that the notes were not issued as part of a general offering to the public because they were issued to only a small group of his close friends on an ad hoc basis. In determining whether there has been a public distribution, however, we look to the need of the offerees for the protectionsafforded by the securities laws. 23 We have previously found that a sale of as few as five notes to members of the general public, including customers, can constitute a sale of securities. 24 Moreover, the fact that the customers may have been friends of McNabb does not mean that the notes were not publicly distributed. As we previously stated,
[i]t is not unusual . . . for investors to have a social relationship with a registered representative. The existence of a social relationship does not mean, however, that such an investor would not be entitled to the same protections that a stranger to the offeror would receive in an offering under the federal securities laws. 25
3. Reasonable Expectations of the Investing Public. In determining whether notes are reasonably perceived by the investing public as securities, we consider whether they would reasonably be viewed by purchasers as investments. 26 When a seller refers to notes as "investments," prospective purchasers may reasonably regard them as investments, absent contrary indications. 27
A balance sheet prepared by McNabb for one of the note holders listed the promissory note under the heading "invested assets." McNabb identified himself as a Registered Investment Advisor incorrespondence pertaining to the notes, which he wrote on RKM letterhead. 28
One customer stated in his declaration that he did not regard the money loaned to McNabb as an investment. Two other customers stated that they did not view the transactions as involving securities. At the same time, however, several customers explicitly compared their arrangements with McNabb to investments in stocks or bonds.
On balance, we find that the investing public would reasonably consider the promissory notes to be investments.
4. Need for Application of the Federal Securities Laws. No alternative scheme of regulation or other factor reduces the risk of the promissory notes at issue here, so as to make application of the federal securities laws unnecessary. Indeed, McNabb argues reduced risk only with respect to the one promissory note secured by a deed of trust. There is no evidence that the deed of trust was recorded, however, nor is there evidence as to the value of the property subject to the deed of trust. McNabb argues that, because this note is secured by a deed of trust, it is "subject to regulation by the California Department of Real Estate," but he does not explain what this alternative regulatory scheme entails and does not argue that it offers protections comparable to those afforded by the federal securities laws. 29 We therefore conclude that the protection of the federal securities laws should apply to the holder of the note secured by a deed of trust, as well as to the other note holders.
We find that the promissory notes were securities and that McNabb's sale of the notes without giving notice to his employer violated Rules 2110 and 3040. 30
Conduct Rule 2310 requires NASD members who recommend the purchase of a security to customers to have reasonable grounds for believing that the security is suitable for the customer. The NASD found that McNabb made unsuitable recommendations to three customers, all of whom purchased promissory notes from McNabb.
The first customer completed a new account form indicating that his annual income was at most $50,000 and his net worth (excluding home and automobiles) was at most $100,000. The $105,000 note that McNabb sold this customer represented twice the customer's annual income and more than his liquid net worth as disclosed on his new account form. 31
The record contains new account forms and an investor questionnaire for the second customer, a married couple whose ages were 72 and 68. 32 According to these forms, the couple's annual income was more than $100,000, their liquid assets totaled $85,000, and their net worth (excluding home) was $204,000. McNabb recommended that this couple purchase unsecured promissory notes totaling $75,000.
The record also contains a new account form and an investor questionnaire for the third customer, a 75-year-old architect. These forms show that the customer's annual income was at most $50,000, and her net worth (excluding home) was $255,000. McNabb recommended that this customer purchase an unsecured promissory note for $209,000.
McNabb acknowledged that it would generally be highly imprudent for customers to lend money to their investment advisors:
[I]f a client of mine came to me and told me that their investment advisor was asking them to borrow individual [sic] money I would tell them that the guy's a crook, don't trust him. Especially if the loan is unsecured, I would tell them that they were stupid. And I would tell them that I would want no part of it, andI'd put a letter in their file saying that I warned them about it.
He contended, however, without explaining why, that it was "absolutely" appropriate for the customers involved in these transactions to lend money to him. In view of the high level of risk the promissory notes posed and the financial situations of these customers, we find that the recommendations to all three customers were unsuitable and that by making these recommendations, McNabb violated Rules 2110 and 2310.
McNabb contends that he was deprived of his right to a fair hearing because the NASD's decision relied on third-party hearsay. A vice president of AIC provided extensive testimony about conversations between the AIC operations manager and several then-current and former RKM employees. Neither the operations manager nor the employees testified.
Hearsay is admissible in administrative proceedings. 33 Indeed, in appropriate circumstances, hearsay may constitute the sole basis for findings of fact. 34 Here, however, we find that the evidence in question was not sufficiently reliable. 35 Much of the hearsay evidence was third-hand. Furthermore, it was not written or signed. There was no showing that any of the declarants were unavailable to testify at the hearing. McNabb's testimony contradicted the hearsay evidence on important points. For these reasons, we do not rely on the hearsay evidence to which McNabb objects, except as to points that McNabb does not dispute. 36
We may cancel, reduce, or require remission of a sanction imposed by the NASD where we find, having due regard for the public interest and the protection of investors, that the NASD's sanction is excessive or oppressive, or imposes an unnecessary or inappropriate burden on competition. 37 Here, we make no such finding.
McNabb argues that the sanctions imposed on him are out of proportion to sanctions imposed in other cases. Because the selection of an appropriate sanction depends on the facts and circumstances of each particular case, action taken in other proceedings is not determinative. 38 In this case, in view of the seriousness of McNabb's conduct, we believe that the sanctions imposed by the NASD are appropriate. 39
We find McNabb's conduct to be very troubling, even though we have not sustained each of the NASD's findings of violation. As we have previously noted, Rule 3040 is important: by prohibiting "selling away" from the member firm with which a registered representative is associated, the rule both protects investors from the hazards of unmonitored sales and protects the firm from loss and litigation. 40 Rule 2310 provides important protection to customers by ensuring that registered representatives consider their customers' overall financial situations and recommend only securities transactions appropriate to their circumstances.
We have found that McNabb sold ten securities worth more than $690,000 without notifying his firm. The conduct involved six customers and took place over a fifteen-month period. McNabb was aware that engaging in private securities transactions without giving notice to his employer was prohibited. He had attended compliance meetings at which the rule was discussed and had signed questionnaires stating that he had not engaged in such transactions. The transactions were for McNabb's benefit, since he wanted the money to use in his business. When questioned by his firm before the audit, McNabb tried to conceal the transactions. We have also found that three of the sales of promissory notes involved unsuitable recommendations. By recommending that his customers purchase promissory notes to give him money to use in his business, McNabb put his own interests ahead of those of his customers. 41
The NASD Sanction Guidelines ("Sanction Guidelines") recommend a fine of $5,000 to $50,000 for selling away violations. 42 They also provide that in more serious cases --including, among other things, those that involve attempts to conceal -- a bar should be standard. 43 For suitability violations, the Sanction Guidelines recommend a fine of $5,000 to $50,000. 44
The fine imposed by the NASD is within the recommended range. 45 In imposing that fine, the NASD specifically considered as a mitigating factor that McNabb had met his obligations to his customers and that none had lost money. In determining that McNabbshould be barred, the NASD noted that McNabb "went to great lengths to conceal these transactions from everyone, including AIC," and found that this attempt at concealment "places this case squarely in the class of 'serious cases' that warrant a bar or suspension." On the basis of the record in this proceeding, we do not find these sanctions either excessive or oppressive.
An appropriate order will issue. 46
By the Commission (Chairman LEVITT and Commissioners HUNT, CAREY and UNGER).
Jonathan G. Katz
UNITED STATES OF AMERICA
SECURITIES EXCHANGE ACT OF 1934
Admin. Proc. File No. 3-9886
In the Matter of
ROBIN BRUCE McNABB
ORDER SUSTAINING DISCIPLINARY ACTION TAKEN BY REGISTERED SECURITIES ASSOCIATION
On the basis of the Commission's opinion issued this day it is
ORDERED that the disciplinary action taken by the National Association of Securities Dealers, Inc. against Robin Bruce McNabb, and the Association's assessment of costs, be, and they hereby are, sustained.
By the Commission.
Jonathan G. Katz
1 Rule 2110 requires NASD members to observe "high standards of commercial honor and just and equitable principles of trade" in conducting their business. Rule 3040 provides, among other things, that, prior to participating in any securities transaction outside the regular course or scope of his or her employment, a person associated with a member firm must give that firm prior written notification.
2 Rule 2310 requires, in relevant part, that an NASD member that recommends the purchase or sale of a security to a customer must have reasonable grounds for believing that the recommendation is suitable for the customer based on the customer's other security holdings and financial situation and needs.
3 The NASD also assessed costs.
4 In March 1998, the notes were restated to show that the monthly payments the customers were receiving constituted principal, with interest to be paid at the end of the loan period.
5 The promissory note transactions came to AIC's attention during an earlier related inquiry into whether a customer had been adequately informed of a contingent deferred sales charge in connection with the sale of mutual fund shares.
6 AIC's letter terminating McNabb also stated that McNabb had failed to disclose the loan and lease transactions to AIC, questioned whether McNabb had made adequate disclosures to the customers involved, and stated that McNabb had made untrue statements to AIC.
7 None of the exclusions in Rule 3040(e) is applicable here.
8 15 U.S.C. § 78c(a)(10). While section 3(a)(10) excludes notes with a maturity at the time of issuance of not more than nine months, that exclusion is not relevant here. Id.
9 Reves v. Ernst & Young, 494 U.S. 56, 63-65, 67 (1990) (citing Exchange Nat'l Bank v. Touche Ross & Co., 544 F.2d 1126, 1137-38 (2d Cir. 1976)).
10 Those four factors are: (1) the motivations that would prompt a reasonable buyer and seller to enter into the transaction; (2) the plan of distributing the notes; (3) the reasonable expectations of the investing public regarding whether the instruments were securities; and (4) the presence of any alternative scheme of regulation or other factor that significantly reduces the risk of the instrument so as to make regulation under the securities laws unnecessary. Reves, 494 U.S. at 66-67.
11 Id. at 65. The Supreme Court has identified the following notes as being outside that market: the note delivered in consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing a character loan to a bank customer, a short-term note secured by an assignment of accounts receivable, the note that simply formalizes an open-account debt incurred in the ordinary course of business, and the note evidencing a loan by a commercial bank for current operations. Id.
13 Gerald James Stoiber, Exchange Act Rel. No. 39112 (Sept. 22, 1997), 65 SEC Docket 1309, 1314, aff'd, 161 F.3d 745 (D.C. Cir. 1998).
14 Reves, 494 U.S. at 66.
17 Despite McNabb's explanation that he needed the funds because of cash flow difficulties, we do not find that the promissorynotes were exchanged "to correct for the seller's cash-flow difficulties" within the meaning of Reves. See William Louis Morgan, 51 S.E.C. 622 (1993) (branch office manager who issued promissory notes in return for loans to members of the public, including his own customers, as result of cash flow difficulties in branch office, engaged in private sale of securities).
18 See Gerald James Stoiber, 65 SEC Docket at 1316 (characterizing interest rates ranging from six to twelve percent annually as favorable).
19 Stoiber, 161 F.3d at 750 (citing Reves, 494 U.S. at 67-68).
20 Stephen J. Gluckman, Exchange Act Rel. No. 41628 (July 20, 1999), 70 SEC Docket 418, 423; Pollack v. Laidlaw Holdings,
Inc., 27 F.3d 808, 813 (2d Cir. 1994), cert. denied, 513 U.S. 963 (1994).
21 McNabb said that this statement referred to his setting up a computer program to record information about the loan. We find, however, that even if McNabb intended this statement to have this unusual meaning, a reasonable customer would understand "portfolio" to refer to a collection of investments.
22 Some of the customers stated that they did not view the loans as investments or securities. Such statements are not dispositive. See Gerald James Stoiber, 65 SEC Docket at 1315-16 (notes issued by registered representative to customers in return for loans were securities, despite customers' statements in affidavits that they understood they were making personal loans and did not intend to make investments).
23 Gerald James Stoiber, 65 SEC Docket at 1317. See generally SEC v. Ralston Purina Co., 346 U.S. 119 (1953) (registration requirements apply to a "public offering," whether to a few or to many).
24 William Louis Morgan, 51 S.E.C. at 627. See also Trust Co. v. NNP Inc., 104 F.3d 1478, 1489 (5th Cir. 1997) ("A debt instrument may be distributed to but one investor, yet still be a security.") (citation omitted).
25 Gerald James Stoiber, 65 SEC Docket at 1317.
26 Reves, 494 U.S. at 68-69; Stoiber, 161 F.3d at 751; Pollack, 27 F.3d at 814.
27 Reves, 494 U.S. at 69; Stoiber, 161 F.3d at 751. See also Martin R. Kaiden, Exchange Act Rel. No. 41629 (July 20, 1999), 70 SEC Docket 439, 445 (where seller described instruments and programs as "investments offering . . . high monthly returns," investing public would reasonably expect that instruments were investments).
28 We have not considered letters that McNabb testified were never sent in determining that the investing public would reasonably view the promissory notes as securities.
29 We note that the cases on which Reves relied in discussing this factor involved alternative schemes of federal regulation. See 494 U.S. at 69.
30 The NASD also found that equipment leases entered into by McNabb with two of his customers were securities in the form of investment contracts. Given our finding that the promissory notes issued by McNabb were securities, and the fact that the transactions in them provide an ample basis for the action here, we decline to reach the investment contract issue.
31 Although the note was secured by a deed of trust, as noted above, the record does not show that the deed was recorded, nor does the record show a valuation for the trust property.
32 During its investigation of McNabb, the NASD reviewed copies of questionnaires submitted by eight of McNabb's customers to Commission staff. These questionnaires, among other things, provided information about their financial situation, investment experience and objectives, and experience investing with McNabb.
33 Harry Gliksman, Exchange Act Rel. No. 42255 (Dec. 20, 1999), 71 SEC Docket 892, 901, appeal pending, No. 00-70141 (9th Cir.)(Gallagher); No. 00-70258 (9th Cir.)(Gliksman); Carlton Wade Fleming, Jr., 52 S.E.C. 409, 411 (1995).
34 Harry Gliksman, 71 SEC Docket at 901; Carlton Wade Fleming, Jr., 52 S.E.C. at 411. See also Richardson v. Perales, 402 U.S. 389, 402 (1971); Hoska v. Army, 677 F.2d 131, 138-39 (D.C. Cir. 1982); Calhoun v. Bailar, 626 F.2d 145, 148-49 (9th Cir. 1980) (each generally holding that probative, reliable hearsay may provide the basis for administrative decisions).
35 See Charles D. Tom, 50 S.E.C. 1142, 1145 (1992) (suggesting factors probative of reliability of hearsay, including whether statements are written, signed and made under oath; whether the statements are contradicted by direct testimony; whether hearsay is corroborated; whether the declarant is unavailable; and whether there is possible bias by the declarant).
36 To the extent that the NASD may have relied on hearsay, our de novo review cures any prejudice that may have resulted. Monroe Parker Secs., Inc., Exchange Act Rel. No. 39057 (Sept. 11, 1997), 65 SEC Docket 1030, 1039 n.25 (citing cases).
37 Exchange Act § 19(e)(2), 15 U.S.C. § 78s(e)(2).
38 See, e.g., Butz v. Glover Livestock Comm'n Co., 411 U.S. 182, 187 (1976); Edward C. Farni II, 51 S.E.C. 1118, 1120 n.11 (1994)(citing cases).
39 McNabb also argues that lesser sanctions are appropriate because he has no prior disciplinary record, no customer lost money as a result of the promissory note transactions, and the transactions did not involve fraud. We have taken these factors into account in our review.
40 Stephen J. Gluckman, Exchange Act Rel. No. 41628 (July 20, 1999), 70 SEC Docket 418, 436; William Louis Morgan, 51 S.E.C. at 625.
41 See Stephen Thorlief Rangen, 52 S.E.C. 1304, 1311 (1997) (registered representative who recommended unsuitable use of margin accounts, thus permitting customers to purchase greater amounts of securities and thereby increasing commissions for himself, engaged in serious misconduct).
42 Sanction Guidelines 45 (1996).
43 Among the principal considerations set forth in the Sanction Guidelines for use in determining sanctions for "selling away" violations are the number of transactions and customers involved and the duration of the violative conduct, whether the salesperson had a proprietary or beneficial interest in the transactions, whether the salesperson willfully disregarded known requirements, and whether there were attempts to conceal the activity. Sanction Guidelines at 45. Whether the investment was successful is not to be considered. Id. at 45 n.3.
44 Id. at 52.
45 The $50,000 fine represented $25,000 for the selling away violation and $25,000 for the suitability violation.
46 We have considered all of the parties' contentions. We have rejected or sustained them to the extent that they are inconsistent or in accord with the views expressed herein.