SECURITIES AND EXCHANGE COMMISSION
In the Matter of the Application of
1136 East Stuart Street, Suite 4203
Fort Collins, Colorado 80525
For Review of Disciplinary Action Taken by the
NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC.
OPINION OF THE COMMISSION
REGISTERED SECURITIES ASSOCIATION REVIEW OF DISCIPLINARY PROCEEDING
Violations of Conduct Rules
Conduct Inconsistent with Just and Equitable Principles of Trade
Failure to Inform Employer of Private Securities Transactions
Person associated with member firm engaged in private securities transactions without prior written notification and approval. Held, association's findings of violation and sanctions it imposed are sustained.
Jim Newcomb, pro se.
Jeffrey Holik, Susan L. Beesley, and Nancy C. Libin for NASD Regulation, Inc.
Appeal Filed: December 15, 2000
Last brief received: March 9, 2001
Jim Newcomb, formerly employed as a general securities representative with Princor Financial Services, Inc. ("Princor"), a member of the National Association of Securities Dealers, Inc. ("NASD"), appeals from NASD disciplinary action. The NASD found that Newcomb engaged in private securities transactions in violation of NASD Conduct Rules 3040 and 2110.1 It fined Newcomb $32,000, suspended him for two years from association with any NASD member in any capacity, and assessed costs against him. We base our findings on an independent review of the record.
Newcomb entered the securities business in 1985. From November 1993 through January 20, 1999, he was employed by Princor. He is currently employed by another member firm.
Newcomb was charged with engaging in private securities transactions in which he sold close to $1 million worth of securities and received $12,000 in compensation. Newcomb admits that he engaged in private securities transactions and did not give sufficient notice. However, he claims that the two-year suspension is excessive. We discuss his conduct in order to assess Newcomb's arguments about his sanction.
In June 1997, Newcomb formed Balanced Assets, Inc. ("Balanced Assets"), a Colorado corporation, which he owned withhis wife. At this time Princor's compliance manual did not distinguish between outside business activities covered by NASD Conduct Rule 30302 and private securities transactions covered by Conduct Rule 3040. Princor simply required representatives who were engaged in any outside business activity to provide "prompt" written notice that described the proposed business and stated whether compensation was to be received. Representatives could satisfy Princor's requirements by updating their Form U-4 (the NASD Uniform Application for Securities Industry Registration or Transfer Form). Sometime in June 1997, Newcomb filed an undated Form U-4, stating that through Balanced Assets he would engage in "[f]inancial advising through a corp. rather than a sole proprietorship." He further stated that he would act as president of the new corporation and would "[e]valuate investments and transfers."3
Newcomb admits that his June 1997 U-4 amendment did not accurately describe the work of Balanced Assets. He testified that, when he filed the June 1997 U-4, he had just formed the corporation and had not yet identified the business in which Balanced Assets would engage. He also admitted, however, that at that time he had contemplated offering and selling promissory notes.
On June 5, 1997, Balanced Assets sold a $30,000 promissory note, the first of 90 promissory notes it sold in the subsequent 18 months. Balanced Assets loaned the proceeds to a "factoring company," which, according to Newcomb, in turn purchased short-term accounts receivable from businesses in need of cash. The Balanced Assets notes that Newcomb sold to his customers were demand notes paying ten percent annual interest, compounded quarterly. From June 5, 1997 through December 1998, Newcomb sold Balanced Assets promissory notes to 48 customers for a total of close to $1 million. Newcomb personally solicited each of these sales, and many of Balanced Assets' customers were Newcomb's Princor customers. In 1998 Newcomb paid himself a $12,000 salary from Balanced Assets profits. Newcomb testified that, after he began to sell Balanced Assets notes, he did not amend his U-4 toreflect his activity because at the time he "didn't think Princor care[d] what I [was] doing anyway."
In January 1998 Princor issued a revised compliance manual. The revised manual expressly stated that representatives were required to notify Princor's compliance department in writing prior to discussing, soliciting, or participating in any securities transaction not conducted directly through Princor. It also stated that Princor would inform representatives in writing whether it approved of the particular private securities transactions. On January 31, 1998, Newcomb signed an acknowledgment that he had received and read the revised compliance manual. At the hearing, Newcomb stated that when he read the revised manual he "wasn't sure" whether the changes applied to him. He did not ask anyone in Princor's compliance department about the revised manual's applicability to his transactions. He "eventually talked to an attorney." According to Newcomb, the attorney advised him that Balanced Assets "probably" was engaged in securities transactions that required registration with the Securities and Exchange Commission. On the advice of his attorney Newcomb filed a Form D with the Commission on September 10, 1998.4
Newcomb amended his Form U-4 on September 15, 1998, stating that Balanced Assets loaned "funds to a factoring company." He further represented that Balanced Assets was involved in "[r]aising funds, monitoring transactions and margins to generate an income to the issuer and the originating lenders. No commissions or fees are incurred or paid." Newcomb did not receive a response from Princor, and he continued selling Balanced Assets notes until December 1998. During a routine audit Princor discovered Newcomb's activity and terminated him for cause in January, 1999.
According to Newcomb, sometime after filing his September 1998 Form U-4 amendment, he discussed Balanced Assets with his supervisor, John Burman. He asked Burman whether he should contact Princor's compliance department about his September 1998 U-4 amendment and Burman suggested that he "let sleeping dogslie." Burman testified that he believed that he became aware of Newcomb's activities during the summer of 1998 and did not consider the note sales to be private securities transactions. Burman also stated that he discussed Newcomb's activities with Princor's compliance department without Newcomb's knowledge. The Hearing Panel found Burman's testimony to be vague and not credible.5
There is no evidence that Newcomb presented the Balanced Assets notes as Princor products, and there is no evidence that Princor received any complaints from Newcomb's customers in connection with the sale of the promissory notes. William Wheeler, a long-time customer of Newcomb, testified that he purchased the Balanced Assets note because of the ten percent annual return and because he "liked the idea of being able to withdraw from it quickly." Wheeler also testified that Newcomb clearly identified the note as an investment.
Conduct Rule 3040(a) states, "[n]o person associated with a member shall participate in any manner in a private securities transaction except in accordance with the requirements of this Rule." Newcomb has admitted violating Rule 3040 and stipulated to the facts. Among other things, Newcomb stipulated before the NASD that the notes that he sold were securities. In addition, relying on the advice of counsel Newcomb filed a Form D with the Commission. On appeal, however, Newcomb appears to question whether the notes were securities.
We believe Newcomb's earlier stipulation was correct. The definition of security in the Securities Exchange Act of 1934 includes "[a]ny note."6 In Reves v. Ernst & Young, the Supreme Court considered when a demand note, like those at issue here, is a security within the meaning of Section 3(a)(10) of the Exchange Act,7 and adopted a "family resemblance" test.8 Under thattest, a note is presumed to be a security unless (1) an examination of the note, based on four factors described by the Court, reveals that the note bears a strong resemblance to certain types of notes recognized as being outside the investment market regulated under the securities laws, or (2) based upon the same four factors, the note should be added to the list.9 Thus, the presumption that a note is a security can be rebutted only when the analysis, based on all the evidence, leads to the conclusion that the note is not a security.10 The Reves test reflects Congress' intent to define "security" broadly so as to encompass virtually any instrument that might be sold as an investment.11 The four factors of the first prong of the Reves test are: (1) the motivations that would prompt a reasonable borrower and lender 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.12 Applying the test set forth in Reves, we find that the notes Newcomb sold are securities.
Newcomb claimed that his customers were motivated by a desire to invest in securities and to profit from the notes. The sample note in the record carried an interest rate of ten percent. Newcomb testified that he wanted to provide a safe, relatively liquid investment vehicle to his customers. One customer, Wheeler, testified that he viewed his purchase of the Balanced Assets note as an investment. Newcomb engaged in a plan of general distribution of the notes. He sold a total of approximately $1 million in 90 Balanced Assets notes to more than 47 non-accredited investors from the general public, many of them his Princor customers. A reasonable person would view the Balanced Assets notes as securities, and there is no otherregulatory scheme that would reduce the risk to customers purchasing Balanced Assets notes. Furthermore, based on the characteristics of these notes there is no reason why they should be added to the list of types of notes not regulated by the securities laws.
Newcomb asks that we set aside the suspension imposed by the NASD. Under Section 19(e)(2) of the Exchange Act, we affirm the NASD's sanctions determinations unless we find them excessive or oppressive or an undue burden on competition. 13
A. Rule 3040(b) requires that an associated person give the member firm prior written notice that describes the private securities transaction in detail, including whether he or she has received or may receive selling compensation in connection with the transaction. Newcomb first notified Princor of the existence of Balanced Assets sometime in June, 1997 on an amended Form U-4. This notification, however, made no mention of the sale of promissory notes. Newcomb claims that at the time he did not know what he would do with his newly-created corporation, although he admitted at the hearing that he had considered offering promissory notes. In any event, as early as June 5, 1997 Balanced Assets sold its first note. Newcomb did not amend his U-4 again or otherwise notify Princor in writing about his activities with Balanced Assets for another 13 months.
While Newcomb admits he did not comply with the requirements of Rule 3040, he blames his failure to comply on Princor. He complains that its compliance manual failed to distinguish between outside business activities and private securities transactions. Newcomb states that he assumed that Princor's requirements were the same as the NASD's, and that he did not know that he could look up NASD rules himself. The fact that Princor's original compliance manual did not require separate written notice for private securities transactions does not excuse Newcomb's failure adequately to disclose his activities.14 The original compliance manual still required written notice of all outside business activities. The June 1997 notice Newcomb provided was inaccurate. Moreover, as an associated person of a member firm, Newcomb is responsible for knowing the NASD rules and requirements.15
Furthermore, in 1998 Newcomb received the updated compliance manual that set forth the requirements of Rule 3040 and clearly indicated that Newcomb needed Princor's prior approval before engaging in private securities transactions. Newcomb signed a statement attesting to the fact that he had received a copy of the updated manual and that he had read it. Newcomb testified that after receiving the update, he debated whether he was engaged in private securities transactions. He did not contact Princor's compliance department. Instead, he "eventually" talked to an attorney. The attorney advised Newcomb that the notes he was selling through Balanced Assets were likely securities.
Nevertheless, when Newcomb updated his Form U-4 again in September 1998, his description of Balanced Assets continued to be misleading. The September 1998 Form U-4 described his activities as "raising funds, monitoring transactions and margins" and did not make clear that Newcomb had been and continued to sell notes to Princor customers.
Moreover, the U-4 asserted that "no fees or commissions are incurred or paid." However, Newcomb received $12,000 from Balanced Assets in 1998. Newcomb states that Princor never defined selling compensation to include "salary" and that he did not intend to deceive Princor. Rule 3040 defines "selling compensation" broadly to include any compensation paid directly or indirectly from whatever source in connection with or as a
result of the purchase or sale of a security. Balanced Assets was in the business of selling promissory notes. Any funds Newcomb paid himself from Balanced Assets were a direct result of his private securities transactions, and thus selling compensation under Rule 3040.16
Newcomb further asserts that he discussed Balanced Assets with his supervisor, John Burman, who did not see a problem with Newcomb's activities. The hearing panel did not credit Burman's testimony. It found his testimony to be vague as to the time and nature of his conversations with Newcomb. Even if the hearing panel had determined that Burman was credible, his testimony would not have established that Newcomb was in compliance with Rule 3040. As we have previously made clear, "furnishing notice in writing is necessary for compliance with the rule."17 Newcomb admits that he did not comply with the requirements of Rule 3040.
B. We do not agree with Newcomb's argument that the sanction against him is excessive.18 The NASD guidelines for violations of Rule 3040 provide that the NASD may consider a suspension of up to two years, or "in egregious cases," a bar.19
Newcomb asserts that his violation was a "non-public, technical violation," that "has not harmed the broker-dealer or the public." As we have held on numerous occasions, selling away is a serious violation, and Rule 3040 is designed not only to protect investors from unmonitored sales, but also to protect securities firms from exposure to loss and litigation in connection with sales made by persons associated with them.20 While there is no evidence that Newcomb presented the notes as Princor products, he personally solicited the purchase of all the notes that he sold, and made many of those sales to his existing Princor customers. Newcomb and his wife were the sole owners of Balanced Assets and benefitted from the sale of the notes. The fact that Newcomb did not actively misrepresent Princor's connection to Balanced Assets, and that Newcomb's customers did not complain to Princor about their investment, does not lessen the egregiousness of Newcomb's conduct.21
We are particularly troubled by the fact that, during the eighteen months that Newcomb sold away from Princor without the firm's knowledge, Newcomb amended his Form U-4 twice. Both times he failed to disclose accurately and fully his activities. Even after a lawyer advised him that he likely was engaged in the sale of securities, Newcomb failed to disclose fully and accurately these facts to Princor. We therefore reject Newcomb's argument that the sanctions here are too severe. We have sustained much more severe sanctions in similar cases and would have done so here.
In light of these factors, we find that the two-year suspension is neither excessive nor oppressive.22
An appropriate order will issue.23
By the Commission (Chairman PITT and Commissioners HUNT and UNGER).
Jonathan G. Katz
In the Matter of the Application of
1136 East Stuart Street, Suite 4203
Fort Collins, Colorado 80525
For Review of Disciplinary Action Taken by the
NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC.
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 Jim Newcomb, the NASD's $32,000 fine, the two-year suspension, and the costs assessed, be, and they hereby are, sustained.
By the Commission.
Jonathan G. Katz
1 Conduct Rule 3040 prohibits any person associated with a member firm from participating in any manner in a private securities transaction outside the regular course or scope of his employment without providing prior written notice to the member. Such notice must describe in detail the proposed transaction, the person's proposed role in it, and state whether he has received or may receive selling compensation in connection with the transaction. If the associated person will receive compensation, the person must receive written approval from the member firm.
Conduct Rule 2110 requires that members and associated persons "observe high standards of commercial honor and just and equitable principles of trade."
The NASD's finding that Newcomb violated Rule 2110 along with Rule 3040 is based on the long-standing policy that a violation of another Commission or NASD rule or regulation constitutes a violation of Rule 2110. Stephen J. Gluckman, Securities Exchange Act Rel. No. 41628 (July 20, 1999), 70 SEC Docket 418, 428.
2 Rule 3030 requires associated persons to notify member firms of any "outside business activities."
3 In 1995 and again in early 1997 Newcomb submitted amended Forms U-4 regarding other outside business activities. In 1995 he informed Princor that he would act as a "certified financial planner" by "implementing financial plans for a fee based advisory service," and in May 1997 he notified Princor that he would be engaging in the "[e]valuation and monitoring of [real estate] holdings." Newcomb stated that Princor never expressly approved either of these activities.
4 Regulation D, promulgated under the Securities Act of 1933 (17 C.F.R. § 230.501 - .508) exempts from federal securities registration requirements certain small offerings. The rule requires that information regarding these offerings be furnished to the Commission on Form D, Notice of Sale of Securities Pursuant to Regulation D, Section 4(6) and/or Uniform Limited Offering Exemptions.
Balanced Assets' Form D disclosed that, as of September 10, 1998, 47 non-accredited investors had purchased Balanced Assets securities.
5 The credibility determination of an initial fact-finder is entitled to considerable weight and deference, since it is based on hearing the witnesses' testimony and observing their demeanor. Keith L. DeSanto, 52 S.E.C. 316, 319 (1995), petition denied, 101 F.3d 108 (2d Cir. 1996)(Table). Such determinations can be overcome "only where the record contains `substantial evidence' for doing so." Anthony Tricarico, 51 S.E.C. 457, 460 (1993).
6 15 U.S.C. §78c(a)(10).
7 494 U.S. 56 (1990).
8 Id. at 64-65, 67.
9 See, e.g., Stoiber v. SEC, 161 F.3d 745, 752 (D.C. Cir. 1998) (two of four Reves factors "strongly favor" treating notes as securities), cert. denied, 526 U.S. 1069 (1999).
10 Id. at 749 n.7.
Examples of notes that are not securities include: notes delivered in consumer financing; notes secured by a home mortgage; and notes evidencing a loan by a commercial bank for current operations. Gerald James Stoiber, 53 S.E.C. 171, 175 n.9, petition denied, 161 F.3d 745 (D.C. Cir. 1998).
11 Gluckman, 70 SEC Docket at 422.
12 Reves, 494 U.S. at 66-67.
13 15 U.S.C. §78s (e)(2).
14 See Thomas C. Kocherhans, 52 S.E.C. 528, 531 (1995) (Participants in the securities industry must take responsibility for compliance with regulatory requirements and cannot be excused for lack of knowledge, understanding, or appreciation of these requirements.); Peter K. Lloyd, 51 S.E.C. 200, 202 (1992) (Although firm's compliance manual did not require written notice of private securities transactions, registered representative knew or should have known that such notice was necessary.).
15 Carter v. SEC, 726 F.2d 472, 474 (1983); Sirianni v. SEC, 677 F.2d 1284, 1288 (1982).
16 See William Louis Morgan, 51 S.E.C. 622, 627 (1993) (cash derived from private securities transactions used to finance branch office operations and personal expenses held to be "selling compensation"). See also Jay Frederick Keeton, 50 S.E.C. 1128, 1131 (1992)(Profits on the interests respondent bought himself constitute compensation.).
17 Dale M. Russell, 51 S.E.C. 561, 563 n.9 (1993) (citing Dale Dwight Schwartzenhauer, 50 S.E.C. 1155, 1162 (1992)(emphasis in the original)).
18 The Hearing Panel suspended Newcomb for 90 days and fined him $10,000. Newcomb appealed to the NASD's National Adjudicatory Council ("NAC"), which upheld the Hearing Panel's findings, increased the fine to $32,000, and increased the suspension to two years.
Newcomb also claims that the NAC's sanctions "are a reaction to [his] appeal from the Hearing Panel's decision and insistence on fair sanctions." The NAC may affirm, modify, reverse, increase or reduce any sanction. NASD Rule 9348.
19 NASD Sanction Guidelines (1998 ed.) at 15 ("Selling Away Private Securities Transactions").
In making the determination regarding sanctions, the NASD guidelines call for a consideration of the following factors: 1) whether respondent had a proprietary or beneficial interest in the selling enterprise; 2) whether respondent created the impression that his employer sanctioned the activity at issue; 3)whether respondent sold away to customers of his employer; and 4) whether respondent provided verbal notice of all the relevant factors to his employer.
20 Ronald J. Gogul, 52 S.E.C. 307, 312 (1995); Gluckman, 70 SEC Docket at 436; see also Jay Frederick Keeton, 50 S.E.C. at 1130 (Outside sales activities, even if uncompensated, expose investors to possible losses and employers to possible liability.).
21 See Ronald J. Gogul, 52 S.E.C. at 312.
22 Newcomb argues that the sanctions imposed on him are not proportional to sanctions imposed in other cases. As we have explained repeatedly, "the appropriate remedial action depends on the facts and circumstances of each particular case, and cannot be precisely determined by comparison with action taken in other cases." Keith S. Perkins, Securities Exchange Act Rel. No. 43599 (Nov. 21, 2000), 73 SEC Docket 2784, 2790 n.12 (citations omitted) appeal pending; Butz v. Glover Livestock Comm'n Co., 411 U.S. 182, 187 (1973).
23 We have considered all of the contentions advanced by the parties. We have rejected or sustained them to the extent that they are inconsistent or in accord with the views expressed in this opinion.
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