United States of America
In the Matter of
DONNA N. MOREHEAD,
|ORDER INSTITUTING PUBLIC ADMINISTRATIVE PROCEEDINGS, MAKING FINDINGS, AND IMPOSING REMEDIAL SANCTIONS|
The Securities and Exchange Commission (the "Commission") deems it appropriate and in the public interest to institute public administrative proceedings, pursuant to Section 15(b) of the Securities Exchange Act of 1934 ("Exchange Act") to determine whether Donna N. Morehead ("Morehead" or "Respondent") failed reasonably to supervise a registered representative of FASCO International, Inc. ("FASCO") with a view toward preventing violations of Section 17(a) of the Securities Act of 1933 ("Securities Act"), Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
In anticipation of the institution of these proceedings, the Respondent has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the findings, except that Respondent admits the jurisdiction of the Commission over her and over the subject matter of these proceedings, which are admitted, the Respondent consents to the issuance of this Order Instituting Public Administrative Proceedings, Making Findings and Imposing Remedial Sanctions ("Order"), and to the entry of the findings set forth below.
On the basis of this Order and the Offer submitted by Morehead, the Commission finds1 that:
Donna N. Morehead, age 43, is a resident of Chico, California. From August 1997 through July 2001, she was a registered representative of FASCO International, Inc. ("FASCO"), a broker-dealer registered with the Commission, pursuant to Section 15(b) of the Exchange Act. From September 1999 until she departed FASCO in July 2001, Morehead was also a principal of FASCO, responsible for supervising sales of variable annuities by registered representatives of FASCO. She operated from FASCO's main office in Chico, California. Respondent is currently, and has been since August 2000, a registered representative and principal of another broker-dealer registered with the Commission.
From 1998 through 2001, a former registered representative of FASCO (and of other broker-dealers registered with the Commission) willfully violated Section 17(a) of the Securities Act of 1933 ("Securities Act"), Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, by switching customers between variable annuities in a series of transactions that he knew, or was reckless in disregarding, had no economical value, for the purpose of generating commissions. The representative also made materially misleading statements and omitted to disclose material information to his customers in connection with variable annuity sales, in order to induce customers to switch from one variable annuity to another.
During the period from September 1999 through May 2001, when Morehead was the supervisor of the registered representative at FASCO, approximately 38 customers switched variable annuities in approximately 47 transactions, upon the recommendation of the registered representative. Those transactions resulted in significant direct charges assessed against the customers. The switches also generated hundreds of thousands of dollars in commissions, paid by the annuity issuers. Respondent failed reasonably to supervise the registered representative with a view toward preventing and detecting his securities laws violations. In particular, Respondent failed to investigate adequately red flags raised by the numerous switches of variable annuities and, thus, failed to detect and prevent his fraudulent conduct.
Throughout the time the registered representative was associated with FASCO, including the period when Morehead was his supervisor, he willfully violated Section 17(a) of the Securities Act of 1933 ("Securities Act"), Section 10(b) of the Exchange Act and Rule 10b-5 thereunder by defrauding customers through fraudulent and unsuitable variable annuity switch recommendations and sales. The customers who were defrauded were retired, predominantly over age 70, with limited sources of income and minimal experience with securities, particularly variable annuities. The customers relied upon the registered representative's recommendations in determining whether to purchase, and to switch, variable annuities.
Variable annuities are long-term securities that have insurance-related features. In this case, the variable annuity customers' funds were invested in "separate accounts" that included several subaccounts, which were investment strategies very similar to well-known mutual funds. The principal insurance-related features of variable annuities are annuitization that is, the right to receive a pay out over an annuitant's lifetime or over a term of years and a death benefit (measured, prior to annuitization, under most of the contracts sold at FASCO, as the greater of the initial investment less withdrawals or the current investment value).
Variable annuity issuers charge fees that include annual mortality, expense and administrative fees, as well as fees for the management of the subaccounts by investment advisers. The variable annuities the registered representative sold were also structured so that a sales charge was not incurred upon purchase but was instead charged if, during the first several years, the owner surrendered the contract for cash, withdrew funds from the account, or exchanged the variable annuity for another annuity. Those charges, called surrender charges, were highest during the initial years of the variable annuity, typically starting at approximately six or eight percent of the amount the customer invested. The charges were designed to decrease over the surrender period. Many of the customers of the FASCO registered representative switched variable annuities during the first two years of the surrender period that applied to their initial variable annuity, thereby incurring the highest surrender charges. After switching, the customers began a new surrender period for the new variable annuity, which extended the length of time they were subject to surrender charges in the future.
In numerous transactions, including approximately 47 transactions involving approximately 38 customers occurring between September 1999 and May 2001, when Morehead was the direct supervisor, the registered representative's customers purchased a variable annuity in exchange for another variable annuity, and as a consequence incurred immediate, material costs, including surrender charges or new, extended surrender periods. The registered representative did not perform an adequate quantitative comparison of those costs versus the purported benefits of switching in connection with his recommendations and sales. Instead, he persuaded customers to switch by misleading them about the value of the purported benefits, and by failing to disclose material information about costs and risks, including the surrender charges. Although the customers who switched did not obtain a net benefit in switching, each switch generated a new commission, typically six to eight percent of the value of the new annuity, paid by the annuity company to FASCO and the representative.
From September 1999 through May 2001, Morehead was responsible for reviewing on behalf of FASCO each sale of a variable annuity to determine that the sale was suitable in light of the customer's investment objectives, annual income, net worth, liquidity and tax bracket. According to the firm's procedures, an exchange of one variable annuity for another should have been undertaken only where the registered representative could objectively demonstrate that it would benefit the customer.
Morehead considered certain variable annuity switches submitted for review by the registered representative to raise "red flags." In particular, Morehead was aware that surrender charges were imposed in the switch of one variable annuity for another. Morehead recognized that some switches were within two years of previous sales of variable annuities to the same customers by the registered representative while at FASCO. In addition, she believed that one of the variable annuities that the representative recommended that customers switch out of was one he found satisfactory and continued to recommend to other customers to purchase. Morehead thus requested that the registered representative explain the basis for the switch recommendations.
The registered representative supplied Morehead with explanations for the switches, which he typically gave to her verbally via telephone. On occasion, he provided Morehead with explanations in writing. The most frequently offered justification for switches was that the subaccounts in which the customer had invested had appreciated, and switching was a means to protect the increased value for the customer's estate. However, in most instances, the customer's investment had not appreciated in value, rendering this purported justification demonstrably false.
Morehead did not seek or obtain sufficient, objective information regarding the switch transactions, such as account statements from the variable annuity companies, in order to verify that the registered representative's explanations for the switches were true. In addition, although she was responsible for two examinations of the one-person branch office out of which the registered representative operated, Morehead did not review account statements and correspondence between the registered representative and his customers, nor did she contact any of his customers. As a consequence, the registered representative continued to engage in fraudulent switches throughout his association with FASCO.
Section 15(b)(6) of the Exchange Act, incorporating by reference Section 15(b)(4)(E) of the Exchange Act, authorizes the Commission to sanction a person associated with a broker-dealer if it finds that it is in the public interest to do so and that the person failed reasonably to supervise, with a view toward preventing violations of the federal securities laws, another person subject to her supervision who committed such a violation. The supervisor may establish an affirmative defense if the supervisor can show that she reasonably discharged the duties and obligations incumbent upon her under procedures established by the broker-dealer with whom she was associated at the time of the violations at issue. Supervisors must respond not only when they are "explicitly informed of an illegal act" but also when they are "aware only of `red flags' or `suggestions' of irregularity." In re John H. Gutfreund, Exchange Act Release No. 31554 (Dec. 3, 1992). A supervisor who reviews the sales of registered representatives and is confronted with red flags fails reasonably to supervise when he or she does not take corrective action in response. In re W.J. Nolan & Co., Exchange Act Release No. 34-44833 (Sept. 24, 2001).
Respondent's supervision of the registered representative was deficient in that she failed effectively to carry out her responsibility to review his transactions, including variable annuity switches, with a view toward detecting and preventing securities violations. When confronted with red flags, Morehead relied upon the information provided by the registered representative, including verbal explanations that were demonstrably false. Had Morehead obtained other, objective information regarding the customers' accounts, including the account statements, the registered representative's false justifications would have been exposed.
Accordingly, the Commission finds that Respondent failed to supervise reasonably the registered representative, a registered representative subject to her supervision, with a view to preventing and detecting violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, within the meaning of Section 15(b)(4)(E) of the Exchange Act.
In view of the foregoing, the Commission deems it appropriate and in the public interest to accept the Offer submitted by Respondent and to impose the sanctions specified therein.
Accordingly, IT IS ORDERED that:
A. Respondent be, and hereby is, barred from association in a supervisory capacity with any broker or dealer, with a right to reapply for such association after one year to the appropriate self-regulatory organization, or if there is none, to the Commission.
B. Respondent shall pay a civil money penalty in the amount of $10,000 to the United States Treasury as follows:
1. Respondent shall pay $2,500 no later than fourteen days after the entry of this Order;
2. Respondent thereafter shall make three additional payments of $2,500 each, no later than September 30, 2002, December 31, 2002, and March 31, 2003;
3. Each such payment shall be: (A) made by United States postal money order, certified check, bank cashier's check or bank money order; (B) made payable to the Securities and Exchange Commission, Operations Center, 6432 General Green Way, Alexandria, Virginia, 22312-0003; and (C) submitted under the cover letter that identifies Morehead as a Respondent in these proceedings, the file number of these proceedings, a copy of which cover letter and money order or check shall be sent to the District Administrator, San Francisco District Office, Securities and Exchange Commission, 44 Montgomery Street, 11th Floor, San Francisco, California, 94104.
By the Commission.
Jonathan G. Katz
1 The findings herein are not binding on anyone other than Respondent.
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