SECURITIES AND EXCHANGE COMMISSION
In the Matter of the Application of
JAMES B. CHASE
For Review of Disciplinary Action Taken by the
NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC.
OPINION OF THE COMMISSION
Registered representative of member firm violated NASD suitability rule by recommending and effecting transactions in customer's account without reasonable basis to believe that such recommendations were suitable for the customer. Held, association's findings of violations and sanctions it imposed are sustained.
Appeal Filed: September 24, 2001
Last Brief Received: February 4, 2002
James B. Chase, formerly registered as a general securities representative and a general securities principal with Collopy & Company, Inc. ("Collopy"), a former member firm, appeals from a National Association of Securities Dealers, Inc. ("NASD") disciplinary action. The NASD found that Chase violated NASD Conduct Rules 2310 and 2110 1 by making recommendations to acustomer that were unsuitable. The NASD fined Chase $25,000, suspended him from association with any NASD member in any capacity for one year, and ordered him to requalify by examination as a general securities representative before re-entering the industry. 2 We base our findings on an independent review of the record.
Chase entered the securities industry in 1969. During the period at issue, December 1995 through February 1997, Chase was associated with Collopy as a general securities representative and as a general securities principal. 3 In February 1996, Chase became president, secretary, treasurer and sole owner of Collopy. He left Collopy voluntarily in December 1997, and he is no longer employed in the industry. 4
Yasmin Horvath was a 24-year-old unmarried college student who lived with her mother in her mother's condominium. In July 1994, she received approximately $436,000 worth of securities as part of a court settlement. 5
Horvath's attorney in the court action suggested that she contact Chase concerning the management and investment of her settlement proceeds. Horvath subsequently opened an account with Chase in September 1994 at Megerian, Inc., and deposited her entire net settlement proceeds into the account. 6 Chase testified that he knew at the time she opened the account that these securities comprised essentially all of Horvath's assets. 7 Horvath's original "New Accounts Form" at Megerian indicated that she had no prior investment experience and that her investment objectives were "income" and "low" risk exposure.
Initially, Chase invested Horvath's funds in a conservative mix of asset-backed securities, U.S. Treasury securities, other government and corporate bonds, preferred stocks, and several limited partnerships. During the first six months after opening the account, Horvath withdrew approximately $20,000 from the account for personal expenses. She continued to withdraw money for personal expenses almost every month; by the end of 1995, Horvath had withdrawn almost $173,000. 8
Chase claimed that he met with Horvath and her attorney and explained that either Horvath would have to stop withdrawing money from the account, or she should change her investment objectives. He testified that based on that conversation he believed that Horvath agreed to change her investment objectivesto "growth" and "speculation." 9 There appears to be some confusion as to whether Horvath ever agreed to do so. 10
A. Over-concentration of Account in Female Health Company
From December 1995 through February 1997, Chase recommended and effected for Horvath, or caused to be effected, approximately 102 purchases of common stock in the Female Health Company ("FHC"). 11 By May 1996, Chase had liquidated Horvath's holdings in all other securities and invested 100% of the assets in Horvath's account in FHC.
FHC, originally a division of Wisconsin Pharmacal Company, Inc. ("WPC"), was a start-up company, whose business consisted of manufacturing and selling a single product, a female condom. The product was new and had no established or tested market. Neither FHC, nor its predecessor WPC, had ever generated an operating profit. 12 Between December 1995 and May 1996, whileChase was concentrating more and more of Horvath's account in FHC stock, FHC's losses mounted due to less-than-expected sales. Chase admitted that, at the time he was investing Horvath's money in FHC, he considered FHC stock "speculative" because the company was not making money.
B. The Margin Account
In May 1996, Chase recommended that Horvath open a margin account to enable her to purchase even more FHC shares. Horvath agreed, and Chase used the margin account to purchase more FHC shares for Horvath. He did not purchase any other securities for Horvath, so that her holdings remained concentrated entirely in FHC. Horvath's monthly margin balance throughout 1996 ranged from $43,000 to $195,000. She was charged more than $9,500 in interest on her margin debt that year.
Because of the declining share price of FHC and the resultant margin calls, the net equity in Horvath's account fell from approximately $455,900 in May 1996 (which included her margin balance) to approximately $188,000 in February
1997. 13 Horvath closed her account in February 1997, with a margin balance of almost $84,000, and only $104,110 net equity.
C. The NASD Decisions
1. The Hearing Panel
The Hearing Panel found that Chase violated Conduct Rules 2310 and 2110 by making unsuitable recommendations to Horvath. The Hearing Panel found that Chase improperly recommended that Horvath change her investment objectives. The Hearing Panel also found that Horvath did not, in fact, change her investment objectives. 14 Given Horvath's financial circumstances, the Hearing Panel found that Chase's recommendations that Horvath concentrate all of her investments into one speculative securitywere inherently unsuitable. Finally, the Hearing Panel found that Chase made an unsuitable recommendation when he recommended that Horvath open a margin account to further extend her investments in FHC. Based upon these findings, the Hearing Panel fined Chase $25,000, suspended him from association with any NASD member in any capacity for six months, and ordered him to requalify by examination as a general securities representative before re-entering the industry.
2. The National Adjudicatory Council
On appeal to the National Adjudicatory Council ("NAC"), Chase argued, in part, that the Hearing Panel erred in relying on Horvath's affidavit. He claimed that Horvath did change her investment objectives and that this change made his recommendations suitable.
In response to Chase's objection to the admissibility of Horvath's affidavit, the NAC concluded that, because the Hearing Panel did not analyze the affidavit's reliability, it could not affirm the Hearing Panel's finding that Horvath did not change her investment objectives. However, the NAC determined that the evidence offered in the affidavit was unnecessary to its findings of violations of the NASD Conduct Rules. The NAC found that Chase's recommendations were not automatically made suitable by the alleged change in Horvath's investment objectives when her financial situation and needs remain unchanged. The NAC concluded that, given the fact that Horvath's account contained virtually all of her liquid assets, Chase's recommendations to continue to purchase FHC stock, which led to an over-concentration in FHC, and his recommendation that Horvath use a margin account to purchase still more FHC shares, were unsuitable, and violated Conduct Rules 2310 and 2110. The NAC affirmed the Hearing Panel's sanctions, except that it increased the suspension period to one year.
NASD Conduct Rule 2310 requires associated persons to have "reasonable grounds for believing that the recommendation [they make to customers concerning the purchase, sale or exchange of a security] is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs." Chase admits that he recommended every stock purchase Horvath made during the relevant period, even though some of the confirmation sheets in the record listed her purchases as "unsolicited."
Horvath was an unmarried college student, with virtually no income. Except for a co-ownership interest in a condominium with her mother, her equity account constituted essentially all of her assets. Because of her limited means and net worth, she could not afford the loss of substantially all of the assets she hadinvested in her account with Chase. She also had no investing experience. All of these factors demanded an investment strategy that limited risk.
Instead, Chase recommended that Horvath purchase shares in FHC until her entire portfolio comprised this one investment. FHC was a start-up company with a single, untested product, that never showed any profits. Chase conceded that it was a highly speculative investment. While investing a certain amount of money in more speculative investments might have been justified, concentration of the entire amount in one speculative security created a substantial risk that Horvath could lose all, or virtually all, of her entire account value. We have repeatedly found that high concentration of investments in one or a limited number of securities is not suitable for investors such as Horvath. 15
Chase's recommendation that Horvath open a margin account to purchase additional FHC shares only exacerbated the situation because of the increased costs and risks associated with margin trading. 16 Margin accounts result in the accrual of interestcharges on the amounts borrowed, thereby adding to the amount a security must appreciate to show a profit. 17 Furthermore, margin accounts are at risk to lose more than the amount invested if shares depreciate sufficiently, giving rise to a margin call. 18 If the customer has limited liquid assets available to meet these charges and risks, securities must be liquidated to cover them. A portfolio's concentration in a single, speculative stock greatly enhances the risk that shares will be liquidated at a loss to meet interest charges and any margin calls. 19 This is what happened in Horvath's account. Chase was aware that Horvath had virtually no income or liquid assets. This meant that her FHC shares had to be liquidated to cover interest payments and margin calls. 20 Furthermore, liquidation generated additional commissions to Chase.
Chase makes numerous arguments as to why his recommendations should be considered suitable. First, he states that Horvath was young and wanted to invest in FHC. He distinguishes Horvath from the investors in Rangen and Eugene J. Erdos 21 by arguing that they were elderly, whereas Horvath has a lifetime of earning potential ahead of her. Second, he argues that he fully informed Horvath of the risks of investing in FHC, and that, because Horvath was studying economics in college, and was able to download information about FHC on the internet, she had sufficient knowledge to evaluate the suitability of the investment for herself. He further argues that he notified her mother, accountant, and attorney when FHC purchases were made. Finally, Chase claims that Horvath changed her investment objectives from income and low risk to growth and speculation.
We are not persuaded by Chase's arguments. The fact that Horvath was young with a lifetime of earning potential is notdeterminative. She had no income at the time, and no prospects for any anticipated income. Chase was obligated to consider her financial profile and needs when he made the recommendations. Her youth did not give him license to waste what comprised virtually all of her assets. 22
Moreover, assuming that Horvath did want to invest in FHC, that did not affect Chase's responsibility to recommend a suitable investment. The test for whether Chase's recommendations were suitable is not whether Horvath acquiesced in them, but whether his recommendations were consistent with her financial situation and needs. 23 Here the recommendations were unsuitable not simply because FHC was speculative, but because Horvath's entire portfolio was concentrated in this one, speculative stock.
Similarly, Chase did not satisfy the suitability requirement simply by informing Horvath of the risks of investing in FHC. Mere disclosure of risks is not enough. A registered representative must "be satisfied that the customer fully understands the risks involved and is . . . able . . . to take those risks." 24
Horvath's college education did not provide a sufficient basis for Chase to conclude that she understood her investments. We have previously found that the fact that a person has acollege education does not establish that he or she is "a sophisticated investor." 25 That Chase may have informed Horvath's mother, accountant, and attorney of his purchases of FHC stock for Horvath is irrelevant. His client was Horvath, not her mother, accountant, or attorney. It was Chase's duty to ensure that Horvath understood the risks.
Chase's claim that Horvath changed her investment objectives is equally unavailing. He argues that Horvath "aggressively managed her own affairs" and wanted to "concentrate her portfolio in one potentially high performance stock." Even if we accept Chase's claim that Horvath did change her objectives, a customer's investment objectives constitute only one factor for a broker to consider when determining the suitability of an investment recommendation. 26 As we noted in Charles W. Eye:
[R]egardless of whether [the customer with limited means] appeared willing, or even eager, to pursue "growth" as [the registered representative] understood it, it was [the registered representative's] duty to advise [the customer] against that pursuit to the extent that it was incompatible with her acknowledged needs. 27
We find that Chase violated NASD Conduct Rules 2310 and 2110 by recommending and effecting transactions in Horvath's account so that FHC stock represented 100 percent of her holdings. 28 We find further that Chase violated these rules by recommending that Horvath open a margin account to make more purchases of FHC stock, when virtually all of Horvath's assets were already invested in FHC.
Exchange Act Section 19(e) 29 provides that we will sustain the NASD's sanctions unless we find, having due regard for the public interest and the protection of investors, that the sanctions are excessive or oppressive or impose an unnecessary or inappropriate burden on competition. 30
The NASD fined Chase $25,000, suspended him from association with any NASD member in any capacity for one year, and ordered him to requalify by examination as a general securities representative before re-entering the industry. The NASD Sanction Guidelines for unsuitable recommendations recommends a fine of $2,500 to $50,000 and a suspension of 10 to 30 business days (up to two years or a bar in egregious cases). 31
Chase's misconduct was serious. Chase's unsuitable recommendations continued over a protracted period of time and resulted in substantial losses to his client. Moreover, Chase refuses to accept his responsibility as a registered representative to make suitable investment recommendations to his clients. He attempts to shift responsibility to Horvath, her mother, her attorney and her accountant. Furthermore, histestimony that his only responsibility to his clients is risk disclosure shows a profound misunderstanding of his professional obligations. Chase also has a prior disciplinary history of recommending unsuitable transactions. 32 In light of all of these factors, we find that the sanctions imposed on Chase were not excessive, oppressive or an undue burden on competition. An appropriate order will issue. 33
By the Commission (Chairman DONALDSON and Commissioners GLASSMAN and ATKINS); Commissioners GOLDSCHMID and CAMPOS not participating.
Jonathan G. Katz
Admin. Proc. File No. 3-10586
In the Matter of the Application of
JAMES B. CHASE
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 James B. Chase, and the Association's assessment of costs, be, and they hereby are, sustained.
By the Commission.
Jonathan G. Katz
1 NASD Conduct Rule 2310 requires that, in making securitiestransaction recommendations to their customers, registered representatives have reasonable grounds for believing that the recommendations are suitable for their customers based upon the facts, if any, disclosed by their customers as to their other security holdings and their financial situation and needs. Registered representatives are required before effecting any transactions for their customers to make reasonable efforts to obtain information concerning their customer's financial status, tax status, investment objectives, and such other information used or considered to be reasonable by the registered representatives in making recommendations to their customers.
Conduct Rule 2110 requires that registered representatives "observe high standards of commercial honor and just and equitable principles of trade."
2 The NASD also assessed costs.
3 Chase became associated with Collopy on May 30, 1995, after leaving Megerian, Inc., another NASD member firm. Prior to his association with Megerian, Chase was associated with Robert W. Baird & Co., also an NASD member firm.
4 Since leaving the industry, Chase has been a consultant for the Female Health Company, trading in the stock of which is the subject of this proceeding.
5 This is the approximate net amount she received, after subtracting attorney's fees.
6 Horvath transferred her account from Megerian to Collopy in June 1995.
7 Chase provided the only testimony in the proceeding. According to Horvath's tax returns, her adjusted gross income for 1994 was $6,900.
8 The amounts varied from month to month averaging approximately $4,500 per month, until November 1995. Late in that month Horvath withdrew approximately $125,000, which Chase claims she used to purchase a new condominium with her mother. According to Chase, he sent Horvath's lawyer and accountant duplicates of account statements and confirmation forms from her account. Chase also testified that Horvath's mother and another family acquaintance continued to be involved in Horvath's financial affairs.
9 Chase prepared a new account form dated March 25, 1996 reflecting this primary investment objective change. On the form, Chase inflated Horvath's net worth to $800,000, of which he listed $500,000 as liquid assets, although her brokerage account statements for February and March 1996 list her total account assets at $308,000 and $309,000, respectively. Chase never explained how he arrived at the $500,000 liquid assets figure. He claimed that the $300,000 of non-liquid assets represented the value of a condominium, which Horvath had purchased three months earlier for $250,000.
10 The new account form is in Chase's handwriting, and there is no support in the record independent of this document that Horvath's investment objectives were changed. There also is no evidence, other than Chase's testimony, that Horvath ever agreed to the information contained in the new account form.
11 At approximately this same time, Chase agreed to serve as a placement agent for FHC. Under the terms of his agreement with FHC, Chase would receive compensation in the form of warrants to purchase FHC shares at a discount if he could arrange a certain number of private placements with institutional investors. There is no evidence that Chase sold any FHC stock out of the inventory that he controlled to Horvath, or that he received any compensation from FHC for selling shares to Horvath.
12 In fact, FHC's 1996 Annual report showed operating lossesfor FHC and its predecessor, WPC, going back to 1992. WPC's 1995 Annual Report showed the same result going back to 1991, and declared that since 1988, its operating results had been significantly impacted by expenses related to the female condom product.
13 Chase claims that one reason for the margin calls was that, after opening the margin account, Horvath continued to withdraw significant amounts from her account. The record does not support this claim. In our review, we found no withdrawals by Horvath from the account after April 1996.
14 To make this finding, the Hearing Panel considered an affidavit prepared by Horvath.
15 See Stephen Thorlief Rangen,52 S.E.C. 1304, 1308 (1997) (discussing suitability in the application of the New York Stock Exchange, Inc. rule governing just and equitable principles of trade). In Rangen, the respondent recommended and effected transactions so that, in one instance, one customer's entire net worth was invested in a single stock, and in another, 80 percent of the equity in a customer's account was concentrated in one stock. We found that, "by concentrating so much of their equity in particular securities, [the registered representative] increased the risk of loss for these individuals beyond what is consistent with the objective of safe, non-speculative investing." Id. In Gordon Scott Venters, 51 S.E.C. 292, 293 (1993), we found respondent violated the NASD's suitability rule where the respondent recommended that a 75 year-old widow with no more than $35,000 net worth invest $2,300 in a company that was losing money, had never paid a dividend, and whose prospects were totally speculative. In making our finding, we noted that the registered representative had recommended that the customer invest "an amount of money that was substantial in relation to her limited resources . . ., [and that] [s]uch an investment in [such] a company . . . would be suitable only for an individual who could withstand the loss of the entire principal amount." Id. at 293-94.
16 See, e.g., Charles W. Eye, 50 S.E.C. 655, 658 (1991) (use of margin in account of investor with limited means and needfor income was unsuitable).
17 See Rangen, 52 S.E.C. at 1308.
18 Id. at 1307-08.
19 See F.J. Kaufman, 50 S.E.C. 164, 170 n.25 (1989) ("The amount of liquid assets is particularly relevant to margin purchasers . . . because, if a margin purchaser does not have sufficient liquid assets to meet a margin call, the security will be sold to meet the margin call, usually resulting in a loss to the customer.").
20 For example, Horvath paid $9,500 in interest charges in 1996.
21 47 S.E.C. 985 (1983) (investor was a 75-year old widow).
22 We note that in Rangen, although three of the investors were in their 70s and retired, the fourth investor was 29 years old with a moderate income. The Commission found that this person was an unsophisticated investor who had no desire to risk his principal. 52 S.E.C. at 1307.
23 See John M. Reynolds, 50 S.E.C. 805, 809 (1992) (regardless of whether customer wanted to engage in aggressive and speculative trading, representative was obligated to abstain from making recommendations that were inconsistent with the customer's financial situation), amended on other grounds, Exchange Act Rel. No. 30036A (Feb. 25, 1992), 50 SEC Docket 1839. See also Venters, 51 S.E.C. at 294-95 (notwithstanding client's interest in investing in speculative securities, broker had duty to refrain from recommending such investments when he learned about his customer's age and financial situation); F.J. Kaufman, 50 S.E.C. at 168 ("The suitability rule . . . requires a broker to make a customer-specific determination of suitability and to tailor his recommendations to the customer's financial profile and investment objectives").
24 See, Patrick G. Keel, 51 S.E.C. 282, 284 (1993).
25 See Peter C. Bucchieri, 52 S.E.C. 800, 804 n.9 (1996) (noting that customer's graduate degree from Harvard did not make him a sophisticated investor).
26 See NASD Conduct Rule 2310(b). Chase argues that the NASD Hearing Panel improperly considered an affidavit prepared by Horvath in making its findings. Horvath's affidavit states that she did not change her investment objectives. Chase asks us to rule that the affidavit was not properly admitted, and to find that Horvath did, indeed, change her objectives. The Hearing Panel's decision is not before us on review; rather it is the NAC decision we consider here. The NAC specifically found that the affidavit was "unnecessary to [its] findings," because, even if Horvath had changed her objectives, the NAC concluded that Chase's recommendations were still unsuitable. Because of the NAC's finding, we did not consider the affidavit in our review of its decision.
27 50 S.E.C. at 659. Chase's contention that concentrating in one or two speculative stocks can be a sound investment strategy is beside the point. For the reasons stated in the text, such a strategy was not sound for Horvath. Cf. Larry Ira Klein, 52 S.E.C. 1030, 1038 n.30 (1996) (respondent could not rely on general approval by his supervisors ofcertain bonds as a substitute for an individual determination that any of the bonds were suitable for specific clients).
28 A violation of Conduct Rule 2310 is also a violation of Conduct Rule 2110, which requires a member, in the conduct of his business, to observe high standards of commercial honor and just and equitable principles of trade. See Clinton Hugh Holland, Jr., 52 S.E.C. 562, 566 n.20 (1995), aff'd, 105 F.3d 665 (9th Cir. 1997) (Table).
29 15 U.S.C. § 78s(e)(2).
30 Id. Chase does not claim, and the record does not show, that the NASD's action imposed an undue burden on competition.
31 NASD Sanctions Guidelines (1998 ed.) at 83.
32 In 1991, the state of Wisconsin censured Chase for making unsuitable recommendations to a Wisconsin resident to purchase securities in an oil and gas company that filed for bankruptcy in 1989. In 1995, Chase was censured by the New York Stock Exchange for, among other things, recommending unsuitable transactions to a customer.
33 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.