Securities and Exchange Commission
Securities Exchange Act of 1934
Rel. No. 41989 / October 7, 1999
Admin. Proc. File No. 3-9276
In the Matter of the Application of
Coastline Financial, Inc.
26034 Acero Street
Mission Viejo, CA 92691
Donald Allyson Williams
Mission Viejo, CA 92691
For Review of Action Taken by the
National Association of Securities Dealers, Inc.
Opinion of the Commission
Registered Securities Association Review of Disciplinary Action
Fraud in the Offer and Sale of Securities
Registered broker-dealer and its principal made material misstatements in connection with the offer and sale of securities. Held, association's findings of violation are sustained in part and set aside in part, and the sanctions it imposed are sustained.
Gerald E. Boltz, Michelle D. Boydston and Thomas N. Fitzgibbon, of Bryan Cave LLP, for Coastline Financial, Inc. and Donald Allyson Williams.
Alden S. Adkins, Norman Sue, Jr., and Susan L. Beesley, for NASD Regulation, Inc.
April 8, 1997
Last brief received:
July 1, 1997
Coastline Financial, Inc. ("Coastline"), a member of the National Association of Securities Dealers, Inc. ("NASD"), and Donald Allyson Williams, its president and sole owner, (collectively, "Respondents") appeal from NASD disciplinary action. The NASD found that Coastline, acting through Williams, made material misstatements and omitted to state material facts in connection with the offer and sale of sixty-three promissory notes to forty-eight investors, in violation of Section 10(b) of the Securities Exchange Act of 1934 and Exchange Act Rule 10b-5,1 and that this conduct violated Article III, Sections 1 and 18 of the NASD's Rules of Fair Practice.2 The NASD censured Coastline and Williams, fined them $50,000 jointly and severally, barred Williams from association with any NASD member in any capacity, expelled Coastline from NASD membership, and assessed costs. The NASD further ordered Coastline to repay, with the stated interest, any of the promissory notes mentioned in the complaint that are outstanding and to provide proof of repayment within thirty days of the NASD's decision. We base our findings on an independent review of the record.
This proceeding concerns Respondents' sale of certain promissory notes issued by Southern California Management and Acquisitions, Inc. ("SCMA" or "Company"), a corporation that, like Coastline, is wholly owned by Williams. SCMA purchases oil and gas properties and resells them at a sizeable profit to Onyx Oil & Gas Management, Inc. ("Onyx"), a corporation wholly owned by Williams and his wife. Onyx structures limited partnerships and, acting as general partner, sells to the partnerships at a substantial markup the properties that it acquires from SCMA. Coastline then sells interests in the Onyx limited partnerships through private placement offerings.
Many of the facts in this proceeding are not in dispute. Between February 10, 1993, and September 1, 1994, Respondents sold sixty-three promissory notes issued by SCMA to forty-eight investors. Although the SCMA notes varied in face amount (from $5,000 to $55,000), annual interest rate (from 10% to 20.5%), and term (12 months, 18 months, or 24 months), their other featureswere identical. At the top of each two-page note was the title "SECURED PROMISSORY NOTE" in oversized, bold letters. Each note stated that interest would be paid in fixed monthly installments over the life of the note, with a balloon payment of principal and interest to be paid at maturity. At the bottom of the first page, the notes stated:
This note is secured by AAA RATED U.S. GOVERNMENT AGENCY SECURITIES. The Payee is not required to rely on the above security for payment of this Note in case of default, but may proceed directly against the Promisor(s).
In late March 1994, an investor who had purchased a $15,000 SCMA note from Respondents asked them for proof of the collateral securing her investment. Although by that time SCMA had issued, and Respondents had sold, twenty-six notes with a combined face value of more than $470,000, SCMA had not yet purchased any AAA-rated U.S. government securities. On April 28, 1994, one month after the investor's request, SCMA purchased for $2,260.50 a U.S. Treasury STRIP zero-coupon bond, with a face amount of $15,000 and a maturity date of November 2021. The confirmation states that the bond was purchased for the account of this investor.
Between May 20, 1994, and September 1, 1994, Respondents sold an additional thirty-seven SCMA notes with a combined face value of $630,000. On September 1, 1994, the NASD inspected SCMA's books and records and Coastline's customer records. Thereafter, the NASD instructed Respondents to stop selling the SCMA notes. On September 7, 1994, less than a week after the NASD's inspection, SCMA purchased for $23,870.55 Resolution Funding Corporation ("RFC") zero-coupon bonds with a face amount of $345,000 and a maturity date of January 2030. In late 1994, SCMA made two additional purchases of RFC zero-coupon bonds maturing in April 2030 and with a total face amount of $627,000, for $41,797.32. By mid-1995, however, SCMA had sold all of the zero-coupon bonds, even though more than $800,000 worth of SCMA notes remained outstanding.
At the District Business Conduct Committee ("DBCC") hearing, the NASD introduced copies of SCMA's financial statements for the years ending December 31, 1993 and December 31, 1994, which reflect that SCMA's liabilities exceeded its assets for both years. Bill Shellenberg, Coastline's compliance officer, testified that SCMA had sufficient cash flow to pay the interest due on the notes. He stated that, in 1994, SCMA had acquired oil and gas properties at a cost of $118,578 and then sold portions of those properties to the Onyx limited partnerships for $917,600, and that SCMA had used part of the proceeds to make interest payments of $104,144 to its investors. Shellenberg admitted that, as of December 31, 1994, SCMA would have had toliquidate all of its assets in order to pay off "substantially all of the notes."
A. The NASD concluded that the SCMA notes sold by Respondents stated falsely that the notes were secured by AAA-rated U.S. government securities. The NASD reasoned that, "at many points in time, nothing secured the notes," and that, when SCMA did purchase zero-coupon bonds, the Company was late in doing so, purchased bonds with a market value equal to only a fraction of the face value of the issued notes, and did not designate the bonds as collateral for the notes. The NASD further concluded that Respondents had failed to disclose to the investors that it would be "futile" to seek repayment from SCMA in the event of default, given that SCMA's liabilities exceeded its assets "throughout the relevant period."
Shortly before the DBCC hearing, Respondents submitted into evidence nearly identical declarations signed by thirty-seven of the forty-eight investors. Respondents argue that these declarations establish that any misrepresentations on the face of the notes were cured by other disclosures and were otherwise not material. Each declaration states in general terms that, before purchasing an SCMA note, the investor was made aware of the business of SCMA and its ability to repay the notes. As to the security for the notes, each declaration states that the investor understood "that such AAA-rated securities would be in the form of zero coupon bonds described in" certain Onyx private placement memoranda and that the bonds would be "substantially discounted as also described in" the memoranda.
The bonds were of little moment, the declarations state, because "[m]y representative further discussed that my SCMA note would be secured primarily by the assets of SCMA and secondarily by the heavily discounted bonds . . . ." (Emphasis added.) The declarations state that investors attached no importance to the bonds because - [I]t did not matter that the zero coupon bonds were going to be purchased late or at all because in the event of default, as noted, I was relying on SCMA's business and assets for repayment and was not relying on the discounted zero coupon bonds.
Far from negating any finding of fraud, these declarations confirm it. The declarations could not be more clear that Respondent's customers thought they were buying secured notes; indeed, when they executed the declarations they still thought they had purchased secured notes. The declarations concern only the identity of the collateral, not whether the notes were backedby any collateral at all. The notes state they were "secured" by "AAA-rated U.S. agency government securities;" the investors say they did not care about these government securities because they were told the SCMA notes were "secured" by SCMA's assets. At most, the declarations establish that Respondents substituted one lie for another, because the notes were never secured not by agency securities, not by zero coupon bonds, not by SCMA's assets, and not by anything else. Contrary to what the notes said on their face, and contrary to what the declarations state the customers were told, the notes that were repeatedly described as "secured" were in fact only unsecured promises to pay.
The difference is highly material. As one commentator has noted, "many of the most fundamental principles of commercial law turn on this distinction."3 A holder of a note evidencing a promissor's unsecured promise to repay a debt has no greater claim to the promissor's assets than any other creditor of the promissor. The noteholder will be repaid only to the extent that all the promissor's assets are enough to pay all his liabilities. Where, however, a promise to pay is secured by particular assets, the note holder has a right to look to those assets for satisfaction of the debt, and with respect to those assets has a priority over all unsecured creditors, regardless of their number or the amount of their claims.4 In other words, for a noteholder the difference between a secured and unsecured note can easily be the difference between being repaid and not. In the context of the SCMA notes, if the notes had been secured by zero coupon bonds or by SCMA's assets, the noteholders could have looked to those assets for repayment, regardless of any other unsecured claims against SCMA. Since the notes were not secured, in the event of default the noteholders could look to SCMA's assets only to the extent they were sufficient to pay the claims of the noteholders and all of SCMA's other creditors.
Respondents intimate, while not arguing directly, that by entitling the SCMA notes "secured notes" and in making representations to investors about the "security" for the notes they did not refer to a security interest in any legal sense. Rather, they suggest, they were representing only that the notes were "secure" in the sense that SCMA had assets upon which it could draw to pay the notes if it needed to do so. There is, however, no evidence that the words were used in such an unusual way, much less that they were so understood by the investors.
Even assuming such a generous reading of the record, Respondents are not out of the woods. A thirty-eighth investor, Elizabeth King, edited her declaration to indicate that the majority of its statements did not apply to her dealings with Respondents. Specifically, King wrote on the declaration that she had not received an Onyx PPM and had not been given either information regarding zero-coupon bonds or the chance to review SCMA's financial statements.
At the DBCC hearing, King testified that the only information she received about her investment from her Coastline registered representative was that the note was secured by AAA-rated U.S. government securities. She further testified that, when she asked how secured notes could pay such high interest, the representative told her that the notes were set up that way. Respondents offered no evidence to rebut either King's hearing testimony or the statements in her edited declaration.
For two other investors, the only information in the record regarding Respondents' disclosures to them are their responses to the NASD's questionnaire. In response to the question "What were you told about the assets pledged as a security for this note(s)?," one of these investors said that she had been told nothing, and the other answered "excellent." Respondents offered no evidence to the contrary. Accordingly, we find that Respondents made misstatements as to the security provided for the SCMA notes.5
B. The remaining elements for Rule 10b-5 liability have been met. First, the misstatements clearly were made "in connection with" the offer and sale of the SCMA notes because those misstatements appeared on the face of the notes themselves. Second, for the reasons noted above, the misstatements were material.
Finally, Respondents acted with scienter. Scienter may be shown through intentional or reckless conduct.6 As the sole owner of both SCMA and Coastline, Williams was in a position to dictate both the content of the SCMA notes and how they would be offered to potential investors. As discussed above, both the notes and verbal communications with prospective investors about the notes contained blatantly false statements.
Williams claims that any false statements by Respondents occurred because "we were early in the business" and "didn't have, really, advice of counsel during that particular time." Williams thus appears to suggest that, without the advice of counsel, he could not tell that his statements were false. But Williams stops short of claiming that he believed the notes were in fact secured. Williams did not need a lawyer to tell him that it was false to describe the notes as "secured" when they were not. If he did, he acted recklessly in not seeking legal advice.
Based on the foregoing, we conclude that Respondents violated Section 10(b) and Rule 10b-57 by making material misstatements in connection with the offer and sale of the SCMA notes.
The promissory notes stated that, in the event of default, noteholders were not "required to rely" on the purported security but could "proceed directly against" SCMA. While the statement clearly implies that SCMA had sufficient assets available for payment of the notes in the event of default, the NASD found the statement was misleading because it omitted to state that proceeding against SCMA would be "futile." This is because, throughout the relevant period, SCMA's liabilities exceeded its assets and thus would not generate sufficient proceeds to pay off all the notes. Respondents argue that the statement was not misleading because SCMA had sufficient assets to pay "substantially all of the notes."
The record does not support the NASD's finding that proceeding against SCMA in the event of default would have been futile. There was, to be sure, a scenario under which SCMA's assets would not have been enough to pay all investors all that was owed in all the notes. SCMA's audited financial statements for 1993 and 1994 show assets totaling only 83% and 85%, respectively, of outstanding liabilities. Thus, if SCMA defaulted on all the outstanding notes simultaneously, investors relying on SCMA's assets to pay off their notes could expect, at best, only 85 cents on the dollar.
The notes, however, were not due all at once and did not contain cross-default provisions whereby a default on one wouldhave constituted an event of default on the others. As a result, the fact that liabilities exceeded assets at certain points while the notes were outstanding does not by itself demonstrate that it would have been "futile" for noteholders to pursue legal remedies as to SCMA in the event of default.
While it may be that the statement that investors could "proceed directly against" SCMA was misleading because it omitted facts that would have informed investors of significant risks that they would be less than completely successful, the case against Respondents was neither charged nor litigated on this basis. Accordingly, we set aside the NASD's finding of violation as to the statement that investors could "proceed directly against SCMA" in the event of default.
We have considered the applicable factors outlined in the NASD's Sanction Guidelines8 in reviewing the appropriateness of the sanctions imposed by the NASD here. We conclude that Coastline's expulsion from NASD membership is warranted in the public interest. Although, as the NASD noted, there was no evidence of customer harm, Respondents raised hundreds of thousands of dollars by selling securities through outright falsehoods to forty-eight investors. The number of transactions, the extent of the scheme, and the seriousness of the misrepresentations support the NASD's choice of sanction. Furthermore, we conclude that Williams' misconduct was sufficiently serious to warrant the permanent bar against him. We also sustain the NASD's order that Coastline repay, with the stated interest, any of the sixty-three SCMA notes that remain outstanding. Finally, we sustain the NASD's additional sanctions of a censure, fine, and assessment of costs as we do not find them to be either excessive or oppressive.9
An appropriate order will issue.10
By the Commission
Chairman Levitt, and
Commissioners Johnson, Hunt,
Carey and Unger).
Jonathan G. Katz
-- 15 U.S.C. § 78j(b) 1998; 17 C.F.R. § 240.10b-5 (1998).
--Article III, Section 1 [now Conduct Rule 2110] requires adherence to "high standards of commercial honor and just and equitable principles of trade." Article III, Section 18 [now Conduct Rule 2120] prohibits the offer or sale of any security by means of any manipulative, deceptive, or fraudulent device.
--Carl S. Bjerre, Secured Transactions Inside Out: Negative Pledge Covenants, Property And Perfection, 84 Cornell L. Rev. 305, 309 (1999).
--See generally, e.g., id.; Cohen, Credit Enhancement in Domestic Transactions: Conceptualizing the Devises and Reinventing the Law, 22 Brook. J. Int'l Law, 21, 31-32 (1996).
--The discussion in the text disposes of three of ten investors who did not submit one of the nearly identical thirty-seven declarations. Evidence in the record supports the conclusion that the remaining seven investors were given the same information as the thirty-seven who signed declarations.
-- See Hollinger v. Titan Capital Corp.,914 F.2d 1564, 1568-69 (9th Cir. 1990), cert. denied, 499 U.S. 976 (1991) (citing cases from eleven circuits that have held a showing of recklessness suffices to show scienter).
--15 U.S.C. § 78j(b) 1998; 17 C.F.R. § 240.10b-5 (1998).
--Where respondent has made misrepresentations, the principal considerations for determining sanctions are: (1) prior or other similar misconduct; (2) whether misconduct was part of a larger fraudulent scheme; (3) degree or extent of false and misleading character; (4) number of misrepresentations; (5) number of customers involved; (6) extent of harm or injury to customer(s); (7) whether the misrepresentation was intentional, reckless, or negligent; (8) whether respondent attempted to verify the information conveyed to customers and whether information was clearly designed to mislead; and (9) other aggravating or mitigating factors. NASD Sanction Guidelines (1996) at 34.
--Our review of the NASD's sanctions is governed by Section 19(e)(2) of the Exchange Act, which requires us to determine having due regard for the public interest and the protection of investors whether a self-regulatory organization's sanctions are excessive or oppressive or impose an unnecessary or inappropriate burden on competition. 15 U.S.C. § 78s(e)(2).
-- We have considered all of the contentions advanced by the parties. We reject or sustain them to the extent that they are inconsistent or in accord with the views expressed herein.